Going, Going, Gone

Georgia Bar Association 2020 Banking Law Program

February 27, 2020

The Transition from LIBOR to Alternative Reference Rates

Tina Carew, Associate General Counsel, FHLBank Atlanta

David Bloom, Deputy General Counsel, Truist Financial Corporation, Atlanta

Reggie O’Shields, General Counsel, FHLBank Atlanta

Christina Rissler, Partner, Eversheds Sutherland LLP, Atlanta

Agenda

• The Need for Transition from LIBOR

• Alternatives to LIBOR

• Transition Planning

• Documentation Issues

• Other Issues

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The Need for Transition from LIBOR

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• London InterBank Offered Rate (LIBOR)– Most widely used interest rate benchmark in the world

– Intended to reflect the cost at which large banks can borrow on an unsecured basis in “wholesale” markets

– Based on daily estimates of borrowing costs for a rangeof currencies and periods from a panel of global banks

• Problems with LIBOR – It has increasingly relied on expert judgment rather than actual transaction data

– During the financial crisis, investigations revealed a plot by certain banks to manipulate LIBOR rates for their own gain

– Multiple banks were fined by regulators or settled LIBOR-related lawsuitstotaling over $9 billion

Background

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The Problem with LIBOR

• There are more than 200 trillion of U.S. dollar (USD) LIBOR contracts outstanding

• There is ~$500M of daily 3M LIBOR trades, which are the basis for creating the LIBOR curve

• This creates huge reliance on a small, fragile, and potentially shrinking base rate

• If something abruptly happened to LIBOR, there could be material problems for that $200T of contracts

Priced off $500 million of daily Interbank (LIBOR) tradingSource: LSTA; Second ARRC Report (March 2018)

$200 TRILLION

OF LIBOR BASEDCONTRACTS

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Efforts to Replace LIBOR

• Litigation, lack of robustness, and the small number of transactions underlying LIBOR have led to global efforts to identify alternatives

• Transition initiatives in the U.S. are led by the Alternative Reference Rates Committee (ARRC)

– Formed in November 2014 by the Board of Governors and Federal Reserve Bank of New York (FRBNY)

– Primary responsibilities

• Identify one or more alternative USD reference rates that fit the needs of the market and meet standards of best practice

• Develop plans for voluntary adoption of these rates

• Identify best practices for contract robustness

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Efforts to Replace LIBOR

• Financial Conduct Authority (FCA) is the U.K. regulator of LIBOR – Speeches by Andrew Bailey, the Chief Executive of the FCA, have helped

accelerate LIBOR transition efforts

• July 2017 – Announced that the FCA would no longer persuade or compel panel banks to provide LIBOR quotations after the end of 2021

• July 2018 – Urged market participants to end their reliance on LIBOR

– Clarified that discontinuation of LIBOR should not be considered a “black swan” event or remote probability

– Noted that an orderly transition from LIBOR to alternative interest rate benchmarks would contribute to financial stability

• ARRC was reconstituted (“ARRC 2.0”) in March 2018 – Membership was expanded

– Expanded focus on mitigation of risks related to transition away from LIBOR

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Alternatives to LIBOR

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Alternative Reference Rates

• What are the alternatives to LIBOR? – No direct substitutes

– Different alternative risk-free rates in different jurisdictions (e.g., SOFR, SONIA, SARON, TONA, ESTER)

• What is the recommended replacement for LIBOR in the United States?– Secured Overnight Financing Rate (SOFR)

• Measured on the cost to borrow cash overnight collateralized by U.S. Treasuries; calculated based on overnight Treasury repurchase agreement transactions

• Identified by ARRC based on feedback from a consultation and members of its advisory group

• FRBNY began publishing SOFR on April 3, 2018

• Fed evaluating SOFR averages and indices including forward-looking rates

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Differences Between LIBOR and SOFR

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LIBOR SOFR• Forward-looking/various terms• Established (30 years+)• Survey +$500 million of daily trading• Unsecured• Available for five currencies• Hypothetically reflects bank cost of

funds• Rises in a market disruption/time of

increased credit risk

• Backward looking/overnight• New as of April 2018• $1 trillion of daily trading• Secured• Only for USD• Risk-free rate• May stay the same or even fall in a

market disruption/time of increased credit risk

Other Potential Reference Rates

• Ameribor®: American Interbank Offered Rate– Disseminated by the American Financial Exchange LLC (AFX)– Based on daily volume-weighted average of transactions between AFX

members in the overnight unsecured loan market• ($1.8B average daily volume in second quarter of 2019)

• ICE US Dollar Bank Yield Index – Developed by ICE Benchmark Administration– Based on two types of USD transactional input data:

• Wholesale unsecured primary funding transactions of large, internationally active banks

• Secondary market transactions in unsecured bonds of large, internationally active banks

– One-month, three-month, and six-month terms– May start publishing in second half of 2020

• Fed Funds Effective Rate or Prime Rate

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Transition Planning

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• ARRC has a Paced Transition Plan for developing SOFR markets and is ahead of schedule

• Industry groups and regulators have emphasized the need to plan and prepare for the LIBOR phase out

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LIBOR

SOFR

Transition Planning

ARRC: Practical Implementation Checklist (September 2019)

1. Establish Program Governance2. Develop Transition Management Program3. Implement Communication Strategy4. Identify and Validate Exposure5. Develop Product Strategy6. Risk Management7. Assess Contractual Remediation Impact and Design Plan8. Develop Operational and Technology Readiness Plan9. Accounting and Reporting10. Taxation and Regulation

What Needs to Be Done?

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Documentation Issues

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“You can imagine the litigation risk when the reference rate for a 20-year contract disappears and there’s no clear path to replace it. Now imagine $190 trillion worth of those contracts. This is a DEFCON 1 litigation event if I’ve ever seen one.”

– Michael Held, Executive Vice President and General Counsel, Federal Reserve Bank of New York

Remarks at the SIFMA C&L Society February Luncheon, New York City (February 26, 2019)

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Potential Risks

• Absence of “fallback language” or temporary “fallback” language may cause a party that receives a lower amount to bring a claim pursuing one or more of the following causes of action:

– Contractual interpretation– Covenant of good faith and fair dealing– Mutual mistake– Impracticability of performance– Securities law claims

• SEC Rule 10b-5 and Section 10(b) of the Securities Exchange Act

• Safest option is to be LIBOR-free well before January 1, 2022 • Early discussions underway on potential legislative solutions, but plan as

if these do not occur

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Potential Risks

• ARRC Consultations – To date, the ARRC has released five consultations proposing draft language for the following types of transactions:

– Floating Rate Notes (September 24, 2018)– Syndicated Business Loans (September 24, 2018)– Bilateral Business Loans (December 7, 2018)– Securitizations (December 7, 2018)– New Closed-end, Residential Adjustable-Rate Mortgages (July 12, 2019)

• ARRC Recommendations – To date, the ARRC has released its recommended USD LIBOR fallback contract language for:

– Floating Rate Notes (April 25, 2019)– Syndicated Business Loans (April 25, 2019)– Bilateral Business Loans (May 31, 2019)– Securitizations (May 31, 2019)– Adjustable Rate Mortgages (November 15, 2019)– Summary of Fallback Language (November 2019)

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ARRC Consultations and Recommendations

• ARRC– Consultation on potential spread adjustment methodologies (open through

March 6, 2019)– Other issues

• SOFR as part of base rate definition?

• Breakage?

• Rate floors?

• Loan Syndications and Trading Association (LSTA)– Compounded SOFR in arrears concept credit agreement (October 2019)

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Loan Documentation

0

10

20

30

40

50

60

May June July August September

4 719

8 9

30

388 26

403

1

6

4

Monthly LIBOR TrackerMay 2019 - September 2019

ARRC Pre-ARRC Other

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Monthly LIBOR Tracker for Public Syndicated Loans

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Key Terms

Averaging Method: An average of daily SOFR rates referenced in FRNs can either be calculated by using a simple or a compound average

Methods to achieve cash flow certainty before an interest payment is due:

• Lookback: The SOFR rate used to calculate a rate for each day in an interest period is based on the SOFR that represents repo transactions on a prior day

• Lockout: One of the daily SOFR rates is “suspended” meaning that it is repeated for several days, typically at the end of an interest period

• Payment Date Delay: Payment dates may be delayed for several days after an interest period concludes

SOFR Floating Rate Notes Comparison ChartAlternative Reference Rates Committee August 2019

Multiple FRNs2018-2019

Goldman SachsFRNsMay 2019

EuropeanInvestment Bank FRNs June 2019; World Bank FRNs July 2019

Morgan Stanley FRNs June 2019; Bank of America FRNs July 2019

StandardOvernight Index Swap (OIS)

Averaging Method

Simple Averaging

Daily Compounding

Daily Compounding

Daily Compounding

Daily Compounding

Payment Date On the interestperiod end date1

On the interestperiod end date

On the interestperiod end date

2 business days following the interest period end date

2 business days following the interest period end date

Lookback 1 business day 2 business days2 5 business days3 No lookback4 No lookback

Lockout Generally 2 business days

None None Only applicable on final interest period: 2 business days

None

Day CountConvention

Actual/360 Actual/360 Actual/360 Actual/360 Actual/360

1. This chart assumes interest generally accrues from, and including, an “interest period end date” to, but excluding, the next “interest period end date.”2. The GS FRN “lookback” applied each daily SOFR rate to the compounding formula based on the observation period date. With a 2-day shift, the observation period starts

and ends two days prior to interest period start and end dates. This formulation can be used to align with hedges.3. The EIB FRN “lookback” applied each daily SOFR rate to the compounding formula based on the applicable interest period date. This is the standard convention in the

SONIA FRN market and a mismatch with swaps may occur around holidays but is minimal when using a 5-day lookback.4. “No lookback” in this chart applies the daily SOFR rate representing repo trading on such day that will be published the following U.S. business day. A “no lookback”

structure requires an additional convention for secondary market trading (e.g. a lockout).

Working Toward SOFR Market Conventions

SOFR Issuance by Market Participants (as of 9/30/19)

FHLBanks account for 51.2 percent of total SOFR issuance

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FHLB $163B

FNMA $21.5B

Financials $45.1B

FHLMC $67.8B

SSA $8.7B FFCB $7.5B

$313.6 Billion in Total SOFR

• SSA = supranationals, sovereigns, and agencies

• FFCB = Federal Farm Credit Bank

• FHLMC = Federal Home Loan Mortgage Corporation (“Freddie Mac”)

• FNMA – Federal National Mortgage Association (“Fannie Mae”)

• International Swaps and Derivatives Association, Inc. (ISDA)– Article 2(2) EU Benchmark Regulation Working Group– Americas and Europe Benchmark Working Group– ISDA Interest Rate Definitions Working Group– ISDA US Documentation and Legal Group– ISDA North American Tax Group– ISDA North America Accounting Group

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Derivatives Documentation

• From July 2018 through December 2019, ISDA launched a series of market consultations regarding the approaches to term and spread adjustments for derivatives fallbacks because the fallback risk-free rates are overnight and risk-free (or nearly risk-free) whereas the relevant IBORs have term structures and incorporate a bank credit risk premium and a variety of other factors (e.g., liquidity, fluctuations in supply and demand)

• Based on these consultations, ISDA expects to supplement the 2006 ISDA Definitions to include the following adjustments:

‒ The Compounded Setting in Arrears Rate is the relevant risk-free rate observed over the relevant IBOR tenor and compounded daily during that period. Backward shift of approximately two banking days will apply; and

‒ The Five-Year Historical Median Approach to the spread adjustment based on the median spread between the IBOR in the relevant tenor and the adjusted risk-free rate over each corresponding tenor (so the spread will differ across different IBOR tenors). Calculated over the five-year period prior to the relevant announcement or publication triggering the fallback provisions (but will not take effect until fallback rates actually apply, if a later date). Will remain constant upon trigger. No transition period.

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ISDA Consultations on Spread and Term Adjustments

• Amendments include new triggers and fallbacks for USD LIBOR and other IBORs and will apply on a going-forward basis to transactions that incorporate the 2006 ISDA Definitions

• Amendments will be implemented via a ‘Supplement’ to the 2006 ISDA Definitions• Upon the effective date of the Supplement, all new derivative transactions that

incorporate the 2006 ISDA Definitions will include the fallbacks (counterparties will not have to take any additional steps)

• ISDA will also publish a Protocol to facilitate inclusion of the amended definitions into existing derivative transactions that were entered into prior to effective date of the relevant Supplement

• Existing derivative transactions entered into prior to the effective date of the relevant Supplement amending the 2006 ISDA Definitions between counterparties that do not both adhere to the protocol, or otherwise (e.g. bilaterally) agree to include the amended definitions in their transactions, will not include the fallbacks

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Amendments to the 2006 ISDA Definitions (in process)

Other Issues

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• On November 13, 2019, the FASB approved an Accounting Standards Update to provide temporary, optional guidance to ease the potential burden in accounting for, or recognizing the effects of, reference rate reform on financial reporting. The Board is expected to issue a final ASU in early 2020.

• The amendments would become effective upon the issuance of a final update and would remain in effect until December 31, 2022, for new and existing contracts and hedging relationships

– Applies to contracts that reference LIBOR or another IBOR that will, or is anticipated to, cease to exist and for which the contract modifications are either essential to or related to the replacement of such interest rate benchmark

– Providing relief by allowing reference-rate modifications to be classified as a continuation for accounting purposes

– Allows hedging relationships to continue despite certain changes being made in the critical terms of an existing hedging relationship due to reference rate reform

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Accounting Issues

• The New York State Department of Financial Services (NYDFS) is requiring each Regulated Institution to submit a response describing its plan to address the LIBOR cessation

• Staff of the SEC published guidance that encourages market participants, including public companies, investment advisers, investment companies and broker-dealers: (1) to make appropriate disclosures of material exposure to LIBOR and (2) to engage in certain activities to manage such risk– On December 30, 2019, the SEC published a public statement on the role

of audit committees in financial reporting and key reminders regarding oversight responsibilities

• Other regulators have issued specific guidance to regulated entities:– Federal Housing Finance Agency– UK Financial Conduct Authority– Bank regulators and FINRA

• US Commodity Futures Trading Commission (CFTC) and others have recently released plain English disclosures

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Disclosure Issues and Other Regulatory Inquiries

• On October 8, 2019, the Department of the Treasury and the Internal Revenue Service released proposed regulations providing guidance on the US federal income tax consequences of changing reference rates in debt and non-debt instruments (e.g., swaps) to rates other than existing IBORs

– The proposed regulations are generally consistent with expectations and provide that replacing LIBOR with a “qualified rate” (including adding such rate as a fallback rate) will not be treated as a modification of an existing instrument

– The proposed regulations will also simplify the tax disclosure provided to prospective investors, counterparties, or customers in connection with the transition with respect to such modifications

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Tax Issues

Thank You

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