LIBOR TRANSITION SERIES: 2021 IS COMING - Virginia Leggett Stevenson Partner, Charlotte Office

LIBOR TRANSITION SERIES:
                                                          2021 IS COMING
                                                          Virginia Leggett Stevenson
                                                          Partner, Charlotte Office
                                                          virginia.stevenson@klgates.com

© Copyright 2019 by K&L Gates LLP. All rights reserved.

Virginia Leggett Stevenson
Partner, Charlotte Office
virginia.stevenson@klgates.com
+1.704.331.7512

LIBOR TIMELINE
 British Bankers’ Association (“BBA”) originally administers LIBOR
  (“BBA LIBOR”).
 LIBOR rate-fixing scandal – starts coming to light in 2008.
 InterContinental Benchmark Exchange (“ICE”) assumes LIBOR
  administration on February 1, 2014.
 On July 27, 2017, the U.K.-based Financial Conduct Authority
  announced that banks will not be required to submit LIBOR values
  to ICE after 2021.
    This isn’t a guarantee that LIBOR will end then, there are concerns that
     LIBOR may become unrepresentative or too “thin” prior to its end.
 The BBA->ICE LIBOR transition illustrates issues that re-appear in
  the transition from ICE LIBOR.
    History doesn’t repeat itself, but it rhymes.

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CURRENT RATES FOR VARIOUS INTEREST
RATE INDICES
 For June 5, 2019:
   Prime: 5.25%
   One-Month US$ LIBOR: 2.42088%
   SOFR (more on this later): 2.39% (reported on 6/5 for
    trade data from 6/4)

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WHAT IS LIBOR?
 It is the London Inter-Bank Offered Rate.

   Note: LIBOR is an unsecured rate.

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LONDON INTER-BANK OFFERED RATE
 London: The banks surveyed for LIBOR are in London.
  They are known as “reference banks.” They may be
  London branches of U.S. (or other) banks -- e.g., Bank of
  America.

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LONDON INTER-BANK OFFERED RATE
 London: The banks surveyed for LIBOR are in London.
  They are known as “reference banks.” They may be
  London branches of U.S. (or other) banks -- e.g., Bank of
  America.
 Inter-Bank: This is the rate a reference bank would be
  charged to borrow money from another bank on an
  unsecured basis.

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LONDON INTER-BANK OFFERED RATE
 London: The banks surveyed for LIBOR are in London.
  They are known as “reference banks.” They may be
  London branches of U.S. (or other) banks -- e.g., Bank of
  America.
 Inter-Bank: This is the rate a reference bank would be
  charged to borrow money from another bank on an
  unsecured basis.
 Offered Rate: The rate is quoted as an annualized rate,
  based on currency, length of time, and the perceived
  creditworthiness of the reference bank.

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INITIAL OBSERVATIONS:
 LIBOR is not the rate at which the reference bank would lend
  money.
     It is the rate at which the reference bank thinks it could borrow from
      another bank.
     It is like an admission if you quote high: other banks wouldn’t think
      we’re as relatively creditworthy as other banks.
 LIBOR is not the rate that would be offered to a non-bank third party
  or the rate the government borrows or lends at.
 For that matter, it is not necessarily the rate at which anything
  actually happens.
     In thin markets, LIBOR is basically “the rate at which banks don’t
      actually borrow from each other.”
 LIBOR is a trimmed average of hypothetical borrowing rates.

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LIBOR MECHANICS
   LIBOR is determined daily on London business days (often, a “LIBOR
    Determination Date”).
   The LIBOR Determination Date is a few business days prior to the accrual
    period to which it applies.
      LIBOR is based on a *spot rate* -- the rate that applies to date when LIBOR is
       set or reset.
      LIBOR is not thought to be subject to great day-to-day variations or sudden
       spikes.
   The accrual period has an associated payment date.
   For bonds:
      Example showing a long delay between when LIBOR is set and when payment
       based on that value is received.
           LIBOR Determination Date may be April 17.
           For the Accrual Period that runs April 19-May 19 (often on a 30/360 basis so that all
            periods are equal).
           Payment for this interest may be on May 20.

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   LIBOR is not just one rate on any given date. LIBOR is announced for a variety of
    currencies:
        U.S. dollars
        pounds sterling
        Japanese yen
        Euro
        Swiss francs
   and 7 maturities / durations (called “tenors”):
        Overnight
        1 week
        1 month
        2 months
        3 months
        6 months
        12 months
   for each LIBOR determination date.

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 For U.S. deals, we are generally interested in LIBOR for U.S. dollars
  as a currency.
 We are also usually looking for U.S. dollar LIBOR for a one-month
  duration (e.g., REMIC certificates). This is usually referred to as
  one-month LIBOR.
 Other times, we are interested in LIBOR for U.S. dollars for a 6-
  month or one-year duration (e.g., FHA ARMs, which reset bi-
  annually or annually after an initial fixed period due to a variable rate
  that is based on 6-month or one-year LIBOR plus a margin).
 Swaps and other derivatives may also reference LIBOR of various
  maturities in U.S. dollars.
 Read your loan or deal documents closely!

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THE VERY OLD OLD:
BBA LIBOR - R.I.P. JANUARY 31, 2014
   The BBA administered LIBOR until January 31, 2014.
   Its LIBOR reporting included more currencies and more tenors than are currently offered.
   Reference banks reported daily for each currency and tenor and these reports were generally
    immediately available for other reference banks to see (prior to July 1, 2013).
   The top quarter and bottom quarter of reported rates were disregarded and the middle half of
    reported rates were averaged to determine what LIBOR would be for each currency / tenor.
   LIBOR submissions for 1-month US$:
    Bank 1                 2.40000%               Bank 9                   2.48500%
    Bank 2                 2.40000%               Bank 10                  2.49000%
    Bank 3                 2.43000%               Bank 11                  2.50000%
    Bank 4                 2.45000%               Bank 12                  2.50000%
    Bank 5                 2.45700%               Bank 13                  2.51000%
    Bank 6                 2.45800%               Bank 14                  2.52000%
    Bank 7                 2.48000%               Bank 15                  3.50000%
    Bank 8                 2.48500%               LIBOR =                  2.47929%
   Trimmed average: the struck-through rates are disregarded and the bolded rates are averaged to
    determine LIBOR.

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ICE LIBOR: THE (FORMERLY) NEW KID ON
THE BLOCK
 If BBA LIBOR was “Under Pressure” by Queen &
  David Bowie, then ICE LIBOR is “Ice, Ice, Baby”
  by Vanilla Ice.
 They are the same in many key respects.
 But there is a key difference.

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ICE LIBOR: BBA LIBOR’S REPLACEMENT
 Effective February 1, 2014
 Intercontinental Exchange Group’s Intercontinental Exchange
  Benchmark Administration Limited is the new LIBOR administrator.
 Initially ICE LIBOR will be calculated in a manner similar to BBA
  LIBOR (i.e., trimmed arithmetic mean).
    There are no guarantees that this will always be the case.
 Because of this change, some deals now feature risk factors
  discussing how LIBOR (however defined and administered) may not
  match the cost of current borrowings, that LIBOR may lose
  prominence as a benchmark interest rate, and that the LIBOR
  methodology may be changed or cease to be viable in the future.

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HOW IS ICE LIBOR DETERMINED?
 Reference banks. First, start with the 17
  reference banks for U.S. dollar-denominated
  LIBOR:
 Bank of America N.A. (London Branch)                Lloyds TSB Bank plc
 Barclays Bank plc                                   MUFG Bank, Ltd
 BNP Paribas SA, London Branch                       National Westminster Bank plc
 Citibank N.A. (London Branch)                       Royal Bank of Canada
 Credit Agricole Corporate & Investment Bank         Sumitomo Mitsui Banking Corporation
 Cooperatieve Rabobank U.A.                          Europe Limited
 Credit Suisse AG (London Branch)                    The Norinchukin Bank
 Deutsche Bank AG (London Branch)                    UBS AG
 HSBC Bank plc
 JPMorgan Chase Bank, N.A. London Branch

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 Reporting in. Second, for each day that is not a weekend
  or a U.K. bank holiday, each reference bank reports in the
  answer to: “At what rate could you borrow funds, were
  you to do so by asking for and then accepting interbank
  offers in a reasonable market size just prior to 11 am
  London time” for the relevant currencies and duration.
    Reasonable market size has been intentionally undefined.
    Rates are quoted in annualized rates regardless of the duration.
    Rates are still just for borrowing, not for converting into or out of
     the particular currency.
    Rates are for borrowing in London, not rates that might prevail
     elsewhere.

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ICE LIBOR METHODOLOGY
 If there are 15 to 18 submissions, the top four and bottom four
  entries are discarded and the remaining entries are averaged to
  determine LIBOR for that day for the relevant currency and duration.
 If there are 11 to 14 submissions, the top three and bottom three
  entries are discarded and the remaining entries are averaged.
 If there are 8 to 10 submissions, the top and bottom two are
  trimmed.
 If there are 5 to 7 submissions, then the top and bottom submissions
  are discarded.
 If there are 4 or fewer “ICE LIBOR is not calculated using the
  standard methodology.”
    We are not sure what this will mean if LIBOR becomes thinly reported
     (e.g., 2021).

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   ICE LIBOR submissions for 1-month US$:
    Bank 1          2.40000%        Bank 9            2.48500%
    Bank 2          2.40000%        Bank 10           2.49000%
    Bank 3          2.43000%        Bank 11           2.50000%
    Bank 4          2.45000%        Bank 12           2.50000%
    Bank 5          2.45700%        Bank 13           2.51000%
    Bank 6          2.45800%        Bank 14           2.52000%
    Bank 7          2.48000%        Bank 15           3.50000%
    Bank 8          2.48500%        LIBOR =           2.47929%

   The struck-through rates are disregarded and the highlighted rates are averaged to
    determine LIBOR.
   Announcement. At approximately 11:45 am London time, the day’s LIBOR values are
    announced. These entries are reported by various subscription services (Reuters,
    Bloomberg, etc.).
   Embargo. Initially, each reference bank’s submission is embargoed. After three
    months, each reference bank’s submission for each tenor becomes public.
    Previously, banks and subscription services were able to get the submissions in the
    grid above immediately (with banks listed by name). Now, only the LIBOR result
    becomes public initially.

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LIBOR MANIPULATION ISSUES
ADDRESSED
 Think back a minute to the question that the
  reference banks are asked to answer: “At what
  rate could you borrow funds, were you to do so
  by asking for and then accepting interbank offers
  in a reasonable market size just prior to 11 am
  London time?”
 What factors might affect a reference bank’s
  LIBOR report?
   How might you mitigate against this?

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LIBOR RATE-FIXING SCANDAL
 To think about: prior to ICE LIBOR, everyone
  used to see what you submitted
  contemporaneously; everyone speculated on
  what that might mean.
 In the LIBOR world, lower submissions are a
  sign of a reference bank’s health.

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LIBOR RATE-FIXING SCANDAL
   Consider our chart again:
    Bank 1         2.40000%       Bank 9           2.48500%
    Bank 2         2.40000%       Bank 10          2.49000%
    Bank 3         2.43000%       Bank 11          2.50000%
    Bank 4         2.45000%       Bank 12          2.50000%
    Bank 5         2.45700%       Bank 13          2.51000%
    Bank 6         2.45800%       Bank 14          2.52000%
    Bank 7         2.48000%       Bank 15          3.50000%
    Bank 8         2.48500%       LIBOR =          2.47929%

   What do you think of the left column vs. the right column?
   What do you think that the red entry might say about Bank 15?
   Do you think that Banks 12 through 14 are relieved that they aren’t in Bank
    15’s shoes?
   If Bank 12 could see Bank 15’s submission from the day before, do you
    think that Bank 12 might submit a rate slightly lower to avoid being the
    highest submitter?

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LIBOR RATE-FIXING SCANDAL
 Factors perceived as affecting reference banks’
  LIBOR reporting
   Views of creditworthiness affect the rate at which
    even big banks can borrow.
   If you are a person with a good credit score, you can
    generally borrow at a lower rate. Conversely, if you
    have a bad credit score, you generally have to borrow
    at a higher rate. Risk, or the perception of risk,
    affects interest rates.

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LIBOR RATE-FIXING SCANDAL
 2008 credit crunch. This is the era immediately before
  and after Lehman’s collapse. Reference banks’ reported
  tenors were available contemporaneously. There was a
  sense that some of the reference banks might have
  problems, particularly banks reporting in the higher
  ranges (even though these rates were disregarded
  outliers for computing LIBOR). Papers such as the WSJ
  began to report that reference banks may have been
  underreporting LIBOR to appear healthier and to suggest
  that lending to them was viewed as less risky than it
  was. Various investigations ensued.

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LIBOR RATE-FIXING SCANDAL: BETTING
WITH THE HOUSE’S $
   Banks are principals in derivatives contracts where payments to be made or
    received by the bank are based on LIBOR; thus, the movement of LIBOR in
    either direction may affect the bank. Back when LIBOR submissions were
    available contemporaneously, it was possible to see where LIBOR was and
    where LIBOR might be going. If banks acted in a concerted manner, it
    might be possible to influence enough reports to move LIBOR higher or
    lower.
   Think of this from the position of Bank 15 (and Bank 14):
    Bank 1          2.40000%          Bank 9           2.48500%
    Bank 2          2.40000%          Bank 10          2.49000%
    Bank 3          2.43000%          Bank 11          2.50000%
    Bank 4          2.45000%          Bank 12          2.50000%
    Bank 5          2.45700%          Bank 13          2.51000%
    Bank 6          2.45800%          Bank 14          2.52000%
    Bank 7          2.48000%          Bank 15          3.50000%
    Bank 8          2.48500%          LIBOR =          2.47929%

   Is much daily variation likely?

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LIBOR RATE-FIXING SCANDAL: HOW TO
MITIGATE THE RISK THAT LIBOR IS
ANYTHING BUT AN ACCURATE MEASURE
OF THE COST OF FUNDS
 Trust but verify:
    Each reference bank must now have a named
     person who is responsible for LIBOR reporting. This
     person is not to be a person who does LIBOR-based
     trading.
       Importance of a named person will reappear later on.
    Each reference bank must keep records.
    LIBOR submissions are now embargoed for 3
     months upon submission and then publicly released.

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SOMETIMES YOU NEED A CARROT.
SOMETIMES YOU NEED A STICK.
 The UK’s Financial Conduct Authority oversees
  the administration of LIBOR.
 LIBOR manipulation is now a crime in the UK
  under the Financial Services Act of 2012.
 The United States DOJ has also pursued
  criminal investigations into LIBOR manipulation.
 Private parties may also sue.

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WHAT IS LIBO?
 LIBO is an alternative method for determining
  LIBOR.
   It was a frequent fallback for determining LIBOR in
    older deals if a value could not be obtained
    traditionally.
   Think of it as DIY LIBOR.
      How many things to you do well the first time you do them?

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WHAT IS LIBO?
 Here is an example of a LIBO definition:
    LIBO Method. Pursuant to this method, LIBOR shall be determined on
     the basis of the offered quotations of the Reference Banks, as those
     quotations appear on the Reuters Screen LIBO Page, to the extent
     available. If not available from the Reuters Screen LIBO Page, the [deal
     party] or its agent will request the Reference Banks to provide the
     offered quotations to the [deal party] as of 11:00 a.m. (London time) on
     that Floating Rate Adjustment Date, and will determine the applicable
     LIBOR based on those quotations.

    So: Someone will make 15 calls and hope that the person who answers
     will give a rate for 1-month LIBOR (unlikely). It is not clear that these
     values are then averaged, but that seems to be what was intended.
     What if there are no quotations?

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LIBO METHOD
 The ICE LIBOR regime embargoes reference bank
  submissions for three months. It is unlikely that in light
  of the prior LIBOR drama that any reference bank would
  give a personal quotation for LIBOR now over the phone.
 Additionally, the use of individual rate submissions once
  released from the 3-month embargo would violate the
  tax rules’ requirement of a “current” rate (discussed later)
  for index-based interest rates.
    Think of it this way – everything becomes stale in three months.

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LIBO METHOD
 The LIBO method is thought to be unworkable now (and
  unworkable should LIBOR proper go away).
 If you run into LIBO on an older deal or older documents, it is worth
  reviewing all of the other definitions and fallbacks/index replacement
  language in detail.
 Post BBA LIBOR, some documents were amended to clarify fallback
  LIBOR language (e.g., Fannie Mae and Freddie Mac  references
  to LIBO will now be treated as references to ICE LIBOR) and other
  fallbacks in case no LIBOR value is obtained or if LIBOR becomes
  thinly reported.
     Read your documents carefully!
     Consider the impact of 2021.

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LOOMING ICE CESSATION AND SOFR,
LIBOR’S HEIR APPARENT (IN THE U.S.)
 Enter SOFR: Secured Overnight Financing Rate
 The Federal Reserve Bank of New York (“FRBNY”) began to publish
  SOFR in April 2018.
 SOFR is thought to have greater daily volatility than other
  comparable market indices.
    As a result, spot SOFR rates are disfavored.
    Instead, SOFR rates are generally obtained and averaged (with
     lookbacks for dates where markets are closed) over a larger window,
     which dampens volatility.
        See Fannie Mae debt issuance pricing supplement from January 28, 2019;
         Ginnie Mae 2019-054.
    SOFR can be averaged or compounded AND averaged in arrears (so
     you won’t know the payment for an accrual period until near its end) or
     in advance.
        Query whether IT systems can handle all calculations and inputs.
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LOOMING ICE CESSATION AND SOFR,
LIBOR’S HEIR APPARENT (IN THE U.S.)
 Risk factors and considerations for switching to SOFR as an interest
  rate index:
    SOFR is a relatively new market index.
    A single methodology for implementing SOFR has not yet been
     established by the market.
    Market terms for debt and securities indexed to SOFR, such as the
     spread over the index reflected in interest rate provisions, may evolve
     over time, and trading prices may therefore be lower than those of later-
     issued SOFR-indexed securities.
    If SOFR does not prove to be widely used that may affect pricing
     compared to examples using another interest rate index.
    SOFR administration: financial systems programmed to pick a spot rate
     and enter it into calculations will need to be re-engineered.
        Consider bank, administrator, billing, reporting, trustee, and IT spend needs
         and the time required to develop, test, and implement changes.

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SOFR – GNR 2019-054 EXAMPLE
 This uses averaging (not compounding) of daily SOFRs:
   SUN         M        TU        W         TH         F        SAT
              1-Apr     2-Apr     3-Apr     4-Apr     5-Apr     6-Apr
    7-Apr     8-Apr     9-Apr    10-Apr    11-Apr    12-Apr    13-Apr
   14-Apr    15-Apr    16-Apr    17-Apr    18-Apr    19-Apr    20-Apr
   21-Apr    22-Apr    23-Apr    24-Apr    25-Apr    26-Apr    27-Apr
   28-Apr    29-Apr    30-Apr    1-May     2-May     3-May     4-May
   5-May     6-May     7-May     8-May     9-May    10-May    11-May
  12-May    13-May    14-May    15-May    16-May    17-May    18-May
  19-May    20-May    21-May    22-May    23-May    24-May    25-May
  26-May    27-May    28-May    29-May    30-May    31-May      1-Jun
    2-Jun     3-Jun     4-Jun     5-Jun     6-Jun     7-Jun      8-Jun
    9-Jun    10-Jun    11-Jun    12-Jun    13-Jun    14-Jun    15-Jun
   16-Jun    17-Jun    18-Jun    19-Jun    20-Jun    21-Jun    22-Jun
   23-Jun    24-Jun    25-Jun    26-Jun    27-Jun    28-Jun    29-Jun
   30-Jun

            Accrual Period is 20th-19th -- we will look at how SOFR is set for the 5/20-6/19 Accrual Period
  Key:
            not U.S. Government Business Day; uses prior business day's SOFR as reported on next U.S. Government Business Day
            so for 4/27 and 4/28, use SOFR at www.newyorkfed.org available on 4/29 (that is based on trades on 4/24)
            SOFR Suspension Period; uses SOFR for first SOFR Reset Date in SOFR Suspension Period
            so for 5/16 and 5/17, use SOFR for 5/16 (that is based on trades on 5/15)

            SOFR for accrual period is calculated two Business Days before end of Accrual Period
            SOFR for Accrual Period of 5/20-6/19 is calculated on 6/17
            For payment on June 20, Trustee uses per annum SOFR using the arithmetic
            average of the daily SOFRs for each day and the actual number of days in the PRIOR accrual period
            (i.e., 4/20-5/19 = 30 days)
            This is the SOFR that will apply to the payment made on 6/20

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SOFR – FANNIE MAE DEBT
 CUSIP for Fannie Mae Notes with SOFR-referencing interest is
  3135G0V67
 Rate is SOFR + 0.075%
 Accrual method is actual/360
 Interest is paid quarterly
 Uses concept of SOFR resetting each day; SOFR during a
  Suspension Period is the SOFR for the day immediately prior to the
  first day of the Suspension Period; if a Reset Date is not a U.S.
  Government Securities Business Day, the SOFR for the next U.S.
  Government Business Day
 Fallbacks: recommended successor, Overnight Bank Funding Rate
  (“OBFR”) from FRBNY; short-term interest rate target from Federal
  Open Market Committee (“FOMC”)

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SOFR – THINGS TO CONSIDER:
   In light of LIBOR  SOFR, SOFR definitions will need their own fallback
    provisions.
   Triggers for implementing changes:
        LIBOR is not published.
        ICE (or the LIBOR Administrator) announces permanent discontinuance of LIBOR.
        Government Supervisor of LIBOR Administrator announces permanent discontinuance of
         LIBOR.
        Determination that LIBOR has become an unrepresentative benchmark (developing).
   Terms include “SOFR Index Cessation Event” and “SOFR Cessation Date”
    for rate and concepts for fallback rates.
   Fallbacks include a replacement index determined by the FRBNY; the
    OBFR designed on the FRBNY website; a rate from the FOMC; other
    indices (plus adjustments or spreads); and then the use of the most recent
    prior SOFR on the SOFR Cessation Date.
   Fallback language must be robust, consider many scenarios, and be
    clear.

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IBORS AND LIBOR:
 LIBOR is common in the U.S.
 In other parts of the world, there are similar “interbank offered rates”
  or “IBORs”.
 Similar to what we see with LIBOR, there is a move to replace
  IBORs with “risk-free rate benchmarks” or RFRs. These vary by
   locality:
      USD LIBOR  SOFR
      CDOR  CORRA
      HIBOR  HONIA
      EUR LIBOR  ESTR
      EURIBOR  ESTR
 General concepts, including fallbacks for fallbacks, are issues there,
  too.

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ANALYTICAL AND DEFINITIONAL ISSUES
 If your industry routinely deals with LIBOR and has a
  trade association, your trade association is probably
  involved in watching developments, polling members re
  best practices and market practice, commenting to
  regulators, and providing updates to members.
 SFIG, CREFC, ISDA, ARRC, etc. are all quite involved.
 Your industry’s exposure and urgency to address issues
  may be driven by asset class duration:
    Assets that have short durations may be seen as less affected.
    Assets with lives of 10-20-30-40-50 years have significant legacy
     LIBOR definitions in documents (e.g., old deals may still refer to
     BBA as LIBOR’s administrator).

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ANALYTICAL AND DEFINITIONAL ISSUES
 For all existing transactions where the parties
  are amenable to amending problematic
  language to add better fallback language:
   Consider waiting until tax guidance is received
    from the IRS/Treasury Department
 For new deals: OK to begin using SOFR and/or
  updating fallbacks on new deals; no need to wait
  for tax guidance.
   Investors and other parties may be more used to
    LIBOR-based rates, but SOFR is catching on.

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SYNDICATED FLOATING RATE LOANS-
LSTA
 LSTA standard definitions are often used in the U.S.
 LIBOR is frequently used.
 Deals may currently include fallbacks to “Base Rate,”
  which may be Prime (or perhaps a money market-based
  rate).
    Note that Prime is currently several points higher than 1-month
     LIBOR and SOFR.
        Margin adjustment may be needed to maintain the status quo.
    Parties may still wish to amend documents to account for a
     different successor to LIBOR and refine cessation date concepts.

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SYNDICATED FLOATING RATE LOANS-LMA
 Loan Market Association (LMA):
    The LMA is UK-based.
    2013 LMA documentation uses a generic label for LIBOR and
     takes account of changes in LIBOR’s administrator and did not
     need any updating for ICE.
    Prior LMA documentation referred to BBA LIBOR and did not
     expressly provide for any change in LIBOR administrator or
     change in label.
        LMA received advice that a court would nevertheless interpret these
         references as references to ICE LIBOR.
    LMA is working on definitions for an RFR similar to what other
     trade associations are doing re LIBOR transition post 2021.

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SWAPS
 ISDA’s definitions are found in swaps and other
  derivatives documentation (in the U.S. and elsewhere).
 If these instruments are issued as part of a certificate
  that represents the interests of both a derivative and a
  REMIC regular interest, the LIBOR definitions in the
  REMIC deal are usually only applicable to the REMIC
  portion of the deal and the ISDA definitions apply to the
  swap.
    They may not move in lockstep if amended separately and with
     different definitions or effective dates.

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SWAPS
 ISDA has been having a series of consultations
  on changing from LIBOR (or IBORs) to a RFR.
   Tenors are an issue to be addressed: RFRs are just
    overnight rates.
   Compounding periods (in advance vs in arrears vs
    what IT systems can actually handle).
   Goal is to develop a protocol that will let two parties
    modify fallback definitions by adhering to the protocol.
   Margin resetting on large volumes of derivatives may
    make parties instead make a one-time true-up
    payment.
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SWAPS
 Using the ISDA Protocol and/or making amendments to
  derivatives could create adverse tax consequences
  absent IRS guidance on this topic:
    If amendment to definitions / changes in spread / true-up were to
     cause a significant modification, the FMV of the derivative on the
     amendment date could be treated as a deemed upfront payment
     (amortized over the term).
    Possibility of deemed loan treatment if the derivative calls for
     significant nonperiodic payments.
    *** Consider waiting for IRS guidance on these issues prior
     to amending documents. ***

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FYI: ISDA 2006 DEFINITIONS
   This is a typical ISDA 2006 definition of BBA LIBOR:
     "USD-LIBOR-BBA" means the rate for a Reset Date will be the rate for deposits in
     U.S. Dollars for a period of the Designated Maturity which appears on the Reuters
     Screen LIBOR01 Page as of 11:00 am, London time, on the day that is two London
     Banking Days preceding that Reset Date. If such rate does not appear on the
     Reuters Screen LIBOR01 Page, the rate for that Reset Date will be determined as if
     the parties had specified “USD-LIBOR-Reference Banks” as the applicable Floating
     Rate Option.”
   While this definition contains BBA in its name, its wording did not create a
    problem under the ICE administration since it ultimately looks to Reuters.
   Note that a LIBO-type method is the fallback method allowed – this was
    common; and it won’t work if LIBOR goes away.
   ISDA Protocol is designed to provide definitions to transition transaction
    documents away from LIBOR.

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ANALYTICAL AND DEFINITIONAL ISSUES
Now that we have seen how there were issues with the administration of BBA LIBOR,
how ICE LIBOR has procedures to address those issues, and how the LIBO method
doesn’t work, where does that leave us for existing transactions?
NOTE: language and fixes may vary by asset class
 January 31, 2014 and prior transactions:
        Do LIBOR definitions and fallbacks still work (if LIBO is a fallback, it isn’t workable)?
        Read all the way to the final fallback – is there any chance that people are instructed to use
         the most recent prior LIBOR?
              This will result in Groundhog Day – most recent prior LIBOR value could be used forever (or until the
               deal is amended).
        RMBS collateral has a very long tail – up to 50 years!
   February 1, 2014 and subsequent existing transactions should account for ICE as
    LIBOR’s current administrator.
        Beware of BBA-era LIBOR-based collateral in new deals  make sure that you’re dealing
         with apples and apples (or disclosing that you aren’t)
        Add definitions to account for LIBOR cessation and transition, including how other indices
         may work differently than LIBOR.
        Check for IT needs and how deal participants will implement.

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ANALYTICAL AND DEFINITIONAL ISSUES
   Today’s 1-month LIBOR is 2.47929 -- why does precision matter? What happens
    when LIBOR goes away?
   Examples:
        A REMIC certificate pays: 6.65% - LIBOR, with a floor of 0.00% and a cap of 0.65%.
        A REMIC certificate pays: 173.41998982% - (25.99999847*LIBOR), with a floor of 0.00%
         and a cap of 173.41998982%.
              Quick math: this bond hits 0.00% around a LIBOR of 6.67%; it has a coupon of 108.9584536% right
               now.
              This would be a great rate to get in perpetuity!
        A REMIC certificate pays: LIBOR + 0.35%, with a floor of 0.00% and a cap of 7.00%.
        A REMIC certificate pays: If LIBOR < 5.65%: LIBOR + 0.95%; If LIBOR > = 5.65%: 74.40%
         (LIBOR x 12); capped at 6.60% (Class MT from Ginnie Mae 2015-138)
              Note: graphing this bond shows a positive slope and then a negative slope: this is called a “mountain
               bond”
   For all of these certificates, particularly the top two, small variations in LIBOR can be
    the difference between getting any interest in a given accrual period. LIBOR is now
    around 2.47949%, but at one point was hovering round 0.10%; a few years before
    that, LIBOR was over 5.0%.

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WHY DO WE CARE – BASIC
 Blame it on the Tax Code.
 For the purposes of identifying (and taxing)
  interest, particularly unstated interest, non-fixed
  interest rates are often “qualified floating rates”
  under Treas. Reg. § 1.1275-5(b)(1).
 “Qualified floating rates” must be set at a current
  value.
    i.e., they can’t be vintage or even slightly stale
 This is applies to debt / lending / hedging / etc.
  transactions.
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QUALIFIED FLOATING RATE:
 Must reasonably be expected to measure
  contemporaneous variations in the cost of newly
  borrowed funds.
 May measure contemporaneous variations in borrowing
  costs for the issuer or for issuers in general.
    LIBOR is such a rate (currently about 2.42088% for 1-month
     LIBOR).
    SOFR: 2.39%  close, but SOFR is more volatile, so its
     average better tracks LIBOR than a daily rate.
    Also: COFI , CMT, Prime (currently about 5.25%, so not
     equivalent to LIBOR).

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CURRENT VALUE
 “A current value is the value of the rate on any day that is
  no earlier than 3 months prior to the first day on which
  that value is in effect and no later than 1 year following
  that first day.” Treas. Reg. § 1.1275-5(a)(4).
 Think about: how does ICE’s 3-month embargoing of
  submissions potentially impact this definition?
    Any ICE LIBOR submissions released from embargo (and rates
     based on them) will be >3 months old by the time they apply to a
     deal, so the rate is stale and does not qualify as a “current” rate.
 We can’t really use old embargoed submissions to craft
  a rate after LIBOR ceases to be published.

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WHY DO WE CARE?
 Treas. Reg. § 1.860G-1(a)(3)(i) allows a REMIC
  regular interest to have interest at a variable rate
  if it is based on a “current interest rate.” Such a
  rate must be a “qualified floating rate” for Treas.
  Reg. § 1.1275-5(b)(1), and it must be set at a
  current value.
    This goes not just to OID (unstated interest on any
     debt instrument), but to REMIC qualification, so it is
     even more important in this area.

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WHY DO WE CARE
 If the interest on debt is tax-exempt, changing interest
  rate indices could lead to a fatal “qualified reopening.”
    Treated as refunding of existing debt; issuing of new debt.
    Need to re-qualify for tax-exempt status for qualified 501c3
     bonds (universities, hospitals).
    Check qualified use of property.
    Need for tax opinions.
    Unclear how nonperiodic payments are treated under Code
     section 103 (tax-exempt interest)/

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WHY DO WE CARE?
 Potential 1.1001-3 deemed reissuance of debt if the index changes
  (or index + spread changes).
    Paradox of Theseus’s Ship
    The Tax Code generally treats a “significant modification” as a taxable
     event.
 Deemed reissuance of swaps could lead to additional tax issues for
  deemed FMV payments for deemed new swaps (that would need to
  be amortized over the swap’s lifetime).
    Possible deemed loan treatment for significant nonperiodic payments.
 Deemed reissuance of floating-rate loans that are REMIC collateral
  could be treated as a taxable REMIC contribution after the startup
  day.

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WHY DO WE CARE
 Deemed reissuance could affect if instruments
  are grandfathered under FATCA (e.g., MX or
  MACR Certificates tied to a related REMIC
  deal).
 Deemed reissuance of debt or instruments held
  by a grantor trust could cause the grantor trust to
  become a taxable entity such as a taxable
  mortgage pool or other taxable entity.
    This treatment is usually fatal as the deal structure is
     based around no entity level taxation.

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WHY DO WE CARE?
 SFIG and the ARRC have requested the IRS to provide
  published guidance that would allow for amendments to
  occur for an orderly post-LIBOR transition without
  adverse tax consequences.
 We will update you via another webinar when this
  occurs.
 The conservative approach on old deals is to prepare for
  amendments but wait until the tax guidance is received
  to adjust language / execute especially in the case of
  REMICs, grantor trusts, swaps and tax-exempt debt.

                          klgates.com                        55

WHY DO WE CARE
 Some preferred stock is treated as equity (not
  debt).
   If this stock has a LIBOR-referenced rate, then
    changing will have tax effects.
   Not a known issue before the IRS at this point.

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WHY DO WE CARE?
 Once tax guidance is released, please note that
  amendments, especially in the REMIC space, may
  require tax options re “no Adverse REMIC events” from
  experienced REMIC counsel and/or 1.1001-3 opinions.
    We will discuss this also on the related webinar.
 Note particularly for REMICs: REMICs frequently have
  other REMICs as their collateral.
    Amending the top layer affects that layer only.
    Collateral documents would need amendments, frequently
     involving other parties (e.g., Lehman, Bear Stearns).

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FINAL THINGS TO NOTE
 Some LIBOR definitions have a final fallback of using the
  immediately prior LIBOR value in the event that all definitions should
  prove to be unworkable (e.g., a LIBO-type fallback).
     Be on the lookout for a springing fixed-rate scenario.
 For other instruments, consider whether it is possible to amend the
  definition and whether this gives one party a benefit that was
  unanticipated (e.g., this has the effect of locking in a rate that
  inversely varies with LIBOR at a very high rate even if ICE LIBOR
  eventually moves in a different direction).
     Consider the more exotic interest rate scenarios we reviewed earlier,
      including Mountain Bonds and TTIBs.

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ISSUES WITH FIXES
 IT: systems are designed to pull one rate on one
  day from one source for LIBOR.
 Margins are all based on margin for LIBOR; if
  the index changes; margins will need to be
  adjusted and INPUT into IT systems.
 SOFR: need to look for rates over a window of
  time (or deemed rate) and then take the
  arithmetic average.
 Spot rate SOFR: some parties may use this as
  a fix (unlikely given SOFR daily volatility).
                      klgates.com                    59

ISSUES WITH FIXES
 If no tax guidance comes from the IRS, index
  changes may be treated as deemed taxable
  exchanges of old debt for new debt, which will
  require valuation (hard to do!) and the issuance
  of 1099s.
   Systems may not be expecting to do this.
   Debt instruments will not value themselves.

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QUICK CHECKLIST
   Existing documents:
      Assume interest rate is LIBOR + margin.
      Review LIBOR definition; fallbacks (including who decides when an index becomes
       unavailable/unrepresentative).
      What are the provisions like for determining when LIBOR has become unavailable?
      Amendment provisions:
          Who needs to consent?
          Is there an opinion (REMIC, tax, other?) requirement?
          Possible changes: index, fallbacks to index, change to margin
                For index: if SOFR, consider if you will use simple arithmetic average, compounding (in advance, in
                 arrears), or spot SOFR rate.
                For change to margin: who decides; how will it work for fallbacks?
                Plumbing fixes re accrual period, suspension periods, method to attach SOFR rates to weekends
                 and holidays.
                SOFR also needs to have fallback language with replacement indices.
          Is there something unique to analyze: FATCA grandfathering, REMIC, tax-exempt debt,
           true-up payments, matching between item and derivative?
          Does ISDA or the ARRC have model language for my asset class?

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QUICK CHECKLIST
 New documents (assuming interest rate is LIBOR + margin).
    New deals are starting now with SOFR as the initial index (and with
     non-LIBOR fallback indices).
        Need to decide how SOFR and other index unavailability will be defined and
         who determines this.
        What will happen to the margin if the index changes?.
    If LIBOR is used: Review LIBOR definition; fallbacks.
        Need to decide how LIBOR and other index unavailability will be defined and
         who determines this.
        Also, what happens if the parties determine that LIBOR has become
         unrepresentative of current borrowing rates even if it is still published?
        What will happen to the margin if the index changes?
        Consider using model language developed by ISDA or the ARRC.

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EXAMPLES FROM OLD DEALS
    LIBOR shall be determined as the rate, expressed as a percentage per
    annum, for one-month U.S. Dollar deposits as it appears on the ICE
    Secure File Transfer Protocol (SFTP) service or on the Reuters Screen
    LIBOR01 Page (or any replacement Reuters page that displays that rate,
    or on the appropriate page of such other information service that publishes
    that rate from time to time in place of Reuters) as of 11:00 am London time
    on the related Floating Rate Adjustment Date.
 This definition reflects the ICE-specific updates discussed in this
  CLE.
 Note fallback in case LIBOR needs to come from somewhere other
  the ICE LIBOR page or somewhere other than Reuters.
 Still, there no fallbacks for a post-LIBOR world.

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EXAMPLES FROM OLD DEALS
 Here is another definition:
    LIBOR shall be determined as the rate equal to the average of the London
    interbank offered rates for one month United States dollar deposits as
    published in the Wall Street Journal thirty days prior to the first day of the
    month in which the related Accrual Period beings (or if such date is not a
    Business Day, the immediately preceding Business Day). If such rate
    ceases to be published in the Wall Street Journal or becomes unavailable
    for any reason, then the rate will be based upon a new index selected by
    the Trustee, from the list of indices approved for use with HUD-insured
    HECMs, which will be announced as soon as it is available.
 Usually deal parties will agree on a replacement index and margin
  or one party will have the right to set these items; it is generally not a
  decision that trustees want to make.
     What if Lehman or Bear Stearns were deal parties and their consent
      would be needed to amend documents?

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EXAMPLES FROM OLD DEALS
   Here is another definition:
     “LIBOR” means . . . the rate per annum appearing on Bloomberg L.P.’s service (the
     “Service”) (or on any successor to or substitute for such Service) for ICE LIBOR
     USD interest rates two (2) LIBOR Business Days prior to the commencement of the
     requested LIBOR Period . . . . If the Service shall no longer report ICE LIBOR USD
     interest rates, or such interest rates cease to exist, Administrative Agent shall be
     permitted to select an alternate service that quotes, or alternate interest rates that
     reasonably approximate, the rates of interest per annum at which deposits of Dollars
     in immediately available funds are offered by major financial institutions reasonably
     satisfactory to Administrative Agent in the London interbank market (and relating to
     the relevant LIBOR Period for the applicable principal amount on any applicable
     date of determination)…
   Note fallback in case LIBOR needs to come from somewhere other than
    Bloomberg.
   Note no provision for changing any margin, just the index.

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EXAMPLES FROM OLD DEALS
   Here is another definition (vintage RMBS):
        As of any Interest Determination Date, the London interbank offered rate for one month U.S. dollar deposits
         which appears on the Reuters Screen LIBOR01 Page as of 11:00 a.m. (London time) on such date. If such
         rate does not appear on the Reuters Screen LIBOR01 Page the rate for that day will be determined on the
         basis of the offered rates of the Reference Banks (as defined herein) for one month U.S. dollar deposits, as
         of 11:00 a.m. (London time) on such Interest Determination Date. The Trustee will request the principal
         London office of each of the Reference Banks to provide a quotation of its rate. If on such Interest
         Determination Date two or more Reference Banks provide such offered quotations, one month LIBOR for the
         related Accrual Period shall be the arithmetic mean of such offered quotations (rounded upwards if
         necessary to the nearest whole multiple of 0.0625%). If on such Interest Determination Date fewer than two
         Reference Banks provide such offered quotations, one month LIBOR for the related Accrual Period shall be
         the higher of (x) one month LIBOR as determined on the previous Interest Determination Date and (y) the
         Reserve Interest Rate. As used in this definition, "business day" means a day on which banks are open for
         dealing in foreign currency and exchange in London and New York City. With respect to the initial Distribution
         Date, One-Month LIBOR shall be 5.149%.
   Note LIBO-type language in the alternatives for establishing the cost of currently-borrowed funds.
   Finally, note the ultimate fallback that if quotations are not available, LIBOR is the higher of the
    prior LIBOR value and the Reserve Interest Rate (usually defined as a LIBOR-ish rate, sometimes
    with NYC banks).

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EXAMPLES FROM A NEWER DEAL
 Here is some fallback language that addresses the question, “What
  if LIBOR goes away?”
   In the event that LIBOR becomes unavailable, [deal party] shall designate
   a new index (approved by __________) based upon comparable
   information and methodology. The [deal party] shall select an
   alternative index only if it receives an Opinion of Counsel that the
   selection of such alternative index will not cause the related Trust
   REMIC or REMICs to lose their classification as REMICs for United
   States federal income tax purposes. If at any time after LIBOR
   becomes unavailable, it again becomes available, the Interest Rates for
   the related LIBOR Classes for each subsequent Accrual Period shall be
   calculated by reference to LIBOR.

   NOTE: no provision for changing any margins in the event the that new
   index is not numerically comparable to LIBOR.

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Virginia Leggett Stevenson
Partner, Charlotte Office
virginia.stevenson@klgates.com
+1.704.331.7512