The End of LIBOR: Proposed Treasury Regulations and Unaddressed Issues
Impacted Financings/Related Swaps
LIBOR-based instruments include, but are not limited to: (i) floating rate loans, notes and bonds, (ii) interest rate swaps, (iii) asset swaps, (iv) collateralized debt obligations (CDOs), (v) credit default swaps (CDSs), (vi) forward rate agreements, (vii) inflation swaps, (viii) total return swaps and (ix) options.
Tax-Exempt Bonds/Related Swaps
Included within categories (i) and (ii) enumerated above are tax-exempt bonds and related interest rate swaps which the US Department of Treasury (Treasury) recently proposed helpful guidance for issuers/borrowers with some caveats.
Many conduit tax-exempt revenue bonds bear interest at a floating rate, most typically a percent of USD 1-month or 3-month LIBOR. Many of these transactions have been synthetically “fixed” by the conduit borrower entering into an International Swaps and Derivatives Association, Inc. (ISDA) interest rate swap transaction in which the borrower pays a fixed rate times a “notional amount” typically designed to mirror the principal balance of its bond debt over the life of the swap. The borrower then receives back a payment based on LIBOR intended to economically match its original bond debt interest obligations.
Proposed Treasury Regulations
On October 9, 2019, Treasury issued Proposed Regulations (84 FR 54068) constituting proposed amendments to the Income Tax Regulations (26 CFR Part 1) under Sections 860G, 882, 1001ja and 1275 of the Internal Revenue Code. These Proposed Regulations outline a number of options which, if used by borrowers and their bondholders (typically a bank or bank affiliate in a direct purchase transaction or public bond market investors in a publicly offered/private placement transaction), and/or if used by borrowers and their bank counterparties (typically, when a bank holds the bonds, the same bank), will allow both the borrowers and their lenders/swap providers to avoid some adverse tax consequences when LIBOR ceases to be available.
There are potentially adverse tax consequences if a transaction (whether a bond or swap) is modified in such a way that it would otherwise be treated for tax purposes as though the pre-existing contract was cancelled and a new contract was entered into ‒ known as a reissuance. A reissuance would, in most cases, result in increased reporting obligations for conduit revenue bond borrowers. In addition, for bondholders and bank counterparties, a reissuance can result in a capital gains tax liability for bondholders/bank counterparties, the cost of which would be expected to be passed along to the borrowers.
To avoid these problems, Treasury has said that if the parties to these sorts of agreements substitute any one of many specifically identified replacement indexes, including the Secured Overnight Financing Rate (SOFR) as recommended by the Alternative Reference Rates Committee (ARRC) and published by the Federal Reserve Bank of New York, a reissuance would not occur. Similarly, if, in connection with a change in rates to an accepted alternative rate, a lump sum payment is made by one party to the other in certain circumstances, and if that payment results in the value of the pre-modification contract (the bond or swap) and the post-modification contract being substantially equivalent, there also is no reissuance.
So far so good (at least from a tax perspective), in particular because it is expected that these lump sum payments, if required, would come from the borrowers. In fact, under the Proposed Regulations, if a lump sum payment of this sort is with respect to an alteration to a bond (not a swap), the payment itself would be tax-exempt, again reducing the potential cost to borrowers.
Although the foregoing is helpful guidance, there are always some qualifications. While some issues may be addressed when the Proposed Regulations are finalized, some cannot be addressed by regulation.
First, what if a borrower has a variable rate (LIBOR-based) bond obligation and an offsetting (LIBOR-based) swap as outlined above, but the bondholders and bank counterparty (whether related entities or not) do not agree to amend their respective contracts to adopt the same alternative index? In that case, although the Proposed Regulations appear to allow the parties to treat the two contracts as still “integrated” for tax purposes (i.e., the bond will still be treated as fixed rate for tax purposes), this potential mismatch of indexes would leave the borrower in a situation where it used to have its variable rate debt effectively fully converted into a fixed rate obligation but now finds itself in a situation in which it remains exposed to the difference between the two indexes if different indexes are adopted by the bondholders and bank counterparties. This is not a problem that can be fixed by regulation.
In addition, what if one of the parties to a transaction (the bondholders or bank counterparty, or even the conduit borrower) refuses to agree to an alternative index? Most older documents were drafted in a setting where the elimination of LIBOR was unimagined, and the documents will not address this. Is it a default? Is it a swap Termination Event and if it is, who is the “Affected Party” (in ISDA parlance)? This, too, cannot be addressed by regulation (and cannot be addressed effectively by ISDA since it cannot retroactively alter swap contracts already in existence).
And what about publicly traded floating rate bonds—how will Bond Trustees (in the absence of 100% bondholder consent) chose a replacement index? Again, a problem that cannot be solved by regulation.
Yield Restriction/Rebate Implications
Importantly, the Proposed Regulations do not address the implications of a lump sum payment of the type described above on yield restriction or rebate relating to tax-exempt bonds. Since the Proposed Regulations provide that a lump sum payment is treated as from “… the same source and character that would otherwise apply to a payment made by the payor with respect to the debt instrument … modified,” if the payment is made with respect to a bond transaction, that payment would, as noted above, appear to be treated as tax-exempt interest and thus logically must be taken into account in calculating yield for rebate and arbitrage yield restriction purposes. This assumption is not addressed explicitly in the Proposed Regulations and clarification of this assumption in the final Regulations might be helpful.
Finally, though SOFR, on average, has tracked LIBOR, there are a number of areas of concern including, but not limited to (i) SOFR was only created last year so there is limited historical tracking experience, (ii) there have been certain periods during the past year (i.e. quarter/year ends) when the rates have not tracked and (iii) in mid-September, SOFR and LIBOR did not track each other for reasons that are not yet clear to the market. As there is a significantly lower counterparty credit risk for SOFR in comparison to LIBOR, this could result in increased costs associated with modifications of the underlying agreements to being based on SOFR. Selecting an appropriate alternative index, timing of implementation and negotiating with bank counterparties, therefore, may require expert guidance.
Related Developments with respect to All LIBOR-Based Instruments
Criticism for Continued Use of LIBOR
There has been general criticism of banks using LIBOR in newly-entered agreements when, in two (2) years, LIBOR is expected to no longer exist.
In fact, the Chair of the Financial Stability Board, an international body that monitors and makes recommendations about the global financial system, recently suggested that the better alternative to incorporating fallback language to deal with the ending of LIBOR is to simply stop using the LIBOR index. He added that relying on fallback language to transition brings a number of operational and economic risks which banks should be incorporating into their continuing use of LIBOR and, importantly, investors and borrowers should consider such risks when they are offered LIBOR-based instruments.
Recently, the Financial Policy Committee (FPC) emphasized that the continued reliance of global financial markets on LIBOR poses risks to financial stability that can be reduced only through a transition to alternative benchmark rates by the end of 2021. It also stated that there was no justification for firms to continue increasing their exposures to LIBOR.
Securities Disclosure Issues
The SEC issued a public statement on the LIBOR transition identifying possible disclosure requirements related to the expected discontinuation of LIBOR, including rules and regulations relating to disclosure of risk factors, management’s discussion and analysis, board risk oversight and financial statement information. The Division of Corporation Finance also suggested considering disclosing (i) the status of efforts to date and the significant matters yet to be addressed, (ii) when a material exposure to LIBOR has been identified but the issuer/borrower does not yet know or cannot yet reasonably estimate the expected impact and (iii) the information used by management and/or the Board in assessing and monitoring the impact of transitioning from LIBOR to an alternative reference rate, including qualitative disclosures and, when material, quantitative disclosures (such as the notional values of contracts referencing LIBOR and extending past 2021).
Upcoming SEC Meeting
To address SOFR volatility and disclosures by municipal issuers, and to provide updates on LIBOR transition and corporate bond transparency, as well as to discuss alternative compensation models for rating agencies and fixed income index construction, the SEC’s Fixed Income Market Structure Advisory Committee (FIMSAC) has scheduled a meeting for Monday, November 4th.
This guidance from the Treasury Department is helpful, but we will have, unfortunately, much work to do to transition LIBOR-based transactions into the post-LIBOR world, and there may be costs incurred in connection with these inevitable changes to LIBOR-based transactions. This is true whether the LIBOR-based transactions are tax-exempt bonds or other financial instruments and their related swaps.
The overall concern is probably best summarized by the President and Chief Executive Officer of the Federal Reserve Bank of New York:
I’ve said it before and I’ll say it again: like death and taxes, the end of LIBOR is unavoidable, and we must do all that it takes to prepare for a LIBOR-less future.
 Including traditional real estate secured financings.
 ISDA is comprised of banks throughout the world including the LIBOR panel banks.
 Several other options for establishing alternate rates are also provided for in the Proposed Regulations.
 ARRC is a group of participants including some of the LIBOR panel banks, Chicago Mercantile Exchange (CME), Chicago Board of Trade (CBOT), CRE Finance Council (CREFC), Fannie Mae, Freddie Mac, Government Finance Officers Association (GFOA), Intercontinental Exchange (ICE) (successor to British Bankers’ Association (BBA)), ISDA, National Association of Corporate Treasurers (NACT) and Structured Finance Association. Ex officio members of ARRC include the Commodity Futures Trading Commission (CFTC), Consumer Financial Protection Bureau (CFPB), Federal Deposit Insurance Corporation (FDIC), Federal Housing Finance Agency (FHFA), Federal Reserve Bank of New York, Federal Reserve Board, Office of the Comptroller of the Currency (OCC), Securities and Exchange Commission (SEC), and Treasury. Observers to ARRC include the Loan Syndications and Trading Association (LSTA) (includes the LIBOR panel banks, other broker/dealers and institutional investors), Securities Industry and Financial Markets Association (SIFMA) and World Bank.
 Historically, this happened on bond financings that were based upon SIFMA (formerly BMA) indices and the swaps were based upon LIBOR which many issuers/borrowers tried to avoid.
 Members include (i) member jurisdictions (e.g. Board of Governors of the Federal Reserve System (the “Board of Governors”), European Central Bank (ECB) and Bank of England (BoE)), (ii) international financial institutions (e.g. International Monetary Fund (IMF), World Bank and Bank of International Settlements (BIS)) and (iii) international standard-setting and other bodies (e.g. Basel Committee on Banking Supervision).
 See The Next Stage in the LIBOR Transition (via prerecorded video), remarks by Randal K. Quarles, Vice Chair for Supervision, Board of Governors at the ARRC Roundtable, cohosted by ARRC and the New York University Stern School of Business and its Salomon Center for the Study of Financial Institutions, New York, New York (June 3, 2019).
 FPC was established in 2013 as part of the new system of regulation in the United Kingdom, including the creation of the U.K. Financial Conduct Authority to replace the U.K. Financial Services Authority. It was formed to improve financial stability after the recent financial crisis. Its 13 members include the Governor, four Deputy Governors, and the Executive Director for Financial Stability Strategy and Risk, of the BoE, as well as seven external members.
 See Financial Policy Summary and Record – October 2019.
 See the section entitled “Division Specific Guidance – Division of Corporation Finance” in the Staff Statement on LIBOR Transition, dated July 12, 2019.
 See Press Release entitled “SEC Issues Agenda for Nov. 4 Meeting of the Fixed Income Market Structure Advisory Committee.” FIMSAC was formed on January 11, 2018.
 Remarks by John C. Williams at the MFA Outlook 2019 entitled “Money Markets and the Federal Funds Rate: The Path Forward,” as prepared for delivery in New York City on October 17, 2019.