Amid the world’s turmoil, we can take comfort in the persistent march of long-foretold events. Keeping to their pre-pandemic promises (at least partially), the Federal Reserve and U.K. regulators[1] of LIBOR have reaffirmed their plans to cease publication of the one-week and two-month LIBORs by the end of 2021. Issuers, holders, and counterparties are slowly and grudgingly waking up to this reality. How are they responding?

In a keynote address at a March 22 symposium on SOFR held by the Alternative Reference Rates Committee (ARRC), Randal K. Quarles, the Vice Chair for Supervision of the Federal Reserve Board, reiterated that LIBOR is not long for this world: “[The ICE Benchmark Administration, which administers LIBOR, known as IBA] will no longer have the necessary panel bank submissions to continue to publish any non-dollar LIBOR tenors or one-week or two-month U.S. dollar (USD) LIBOR after December 31, 2021. IBA will no longer have the necessary panel bank submissions to continue publishing overnight, one-month, three-month, six-month, or one-year USD LIBOR after June 30, 2023.” Lest there be any doubt, Quarles continued: “Adjusting to a new reality can be difficult, so let me be clear: These statements are definitive.” Quarles’s speech is an excellent survey of the landscape and is worth your time to read.

If a debt instrument or a derivative agreement, such as a basis or interest rate swap, requires one party to pay the other party some amount based on LIBOR, and LIBOR is no longer being published, and the document doesn’t provide for an alternate rate mechanism, disaster will ensue. (For example, if an issuer of debt must pay interest to the holder of its debt at a spread over LIBOR, and LIBOR isn’t available and no comparable alternate rate mechanism already exists, then the interest rate on the debt instrument may jump to something very undesirable for the issuer.) This sort of thing is not what the parties intended to be the core economic deal when they entered into the transaction and would likely lead to chaos. So it is in the interest of the parties to tackle this issue now by reviewing all debt and other transactions that have any reference to LIBOR and revising LIBOR-based features in their debts and hedges (such as interest rate swaps) by providing an alternate rate mechanism.

Recognizing the practical hassle and potential for peril presented by a “reissuance” of a debt or a hedge resulting from a change that is meant solely to replace the Betamax of LIBOR with the VHS[2] of a rate that will persist, the IRS wants to help issuers make these changes without causing a reissuance. Indeed, in the IRS’s own words, it wants to “broadly facilitate the transition away” from LIBOR. This is all old news at this point, but we write today to provide some updates and to report from the trenches on the progress of the transition away from LIBOR.

The IRS has so far[3] provided two sources of relief. The first comes to us in the form of Proposed Regulations 1.1001-6. Although they are only in proposed form, we can apply the Proposed Regulations currently.[4] The regulations can be boiled down to a simple sentence: “An alteration to replace a rate referencing an IBOR [e.g., LIBOR] with a qualified rate and any associated alteration are not treated as modifications.”[5] Because these changes aren’t treated as modifications, under the regulatory machinery governing these questions they by definition cannot cause a reissuance of a debt or a termination of a hedge. The complicating factor here, however, will be that a replacement rate is not a “qualified rate” unless the fair market value of the debt or hedge is the same before and after the replacement.

There are safe harbors for ensuring that this requirement is met (because heaven knows no one is going to certify the fair market value of anything). One safe harbor allows the parties to “determine” the fair market value as long as they are “unrelated” (under one of a few characteristically arcane tests of relatedness under the Code) and as long as they take into account the value of any one-time payment made in connection with the change. It is unclear what it means to “determine” that the fair market value of the modified and unmodified instruments is the same and whether, for example, the parties have to obtain that determination from an independent third party such as a financial advisor. One approach we have seen involves language that takes the following form:

The parties may replace the LIBOR Rate with a substantially economically equivalent rate [if certain conditions are met]. A Substitute Rate shall be deemed to be substantially economically equivalent to the LIBOR Rate if the Purchaser and the Issuer are not related[6] . . . and they determine, based on bona fide, arm’s length negotiations, that the fair market value of the Bonds before the substitution is substantially equivalent to the fair market value after the alteration or modification.  If the Purchaser and the Issuer are not related and both the Purchaser and Issuer agree to the Substitute Rate (including any multiplier and spread) then they will be deemed to have determined the Substitute Rate based on bona fide arm’s length negotiations.

This approach seems sensible; after all, the best evidence of fair market value of a piece of property is the determination of that value made by two well-advised parties dealing at arm’s length. Documents following this approach would not require an independent determination of fair market value, unless bond counsel decided to impose it.

A second safe harbor allows the parties to satisfy the fair market value requirement by demonstrating that, at the time of the LIBOR replacement, the historic average of the LIBOR-based rate on the instrument is within 25 basis points of the historic average of the replacement rate. The parties may use any reasonable method to compute a historic average if the lookback period from which the historic data are drawn begins no earlier than 10 years before the alteration and ends no earlier than three months before the alteration, once a lookback period is established, the historic average takes into account every instance of the relevant rate published during that period, and the parties use the same methodology and lookback period to compute the historic average for each of the rates to be compared. If bond counsel and others are comfortable that the fair market value safe harbor can be satisfied using a “presumption” approach similar to the one described above, then this safe harbor may not be necessary.

The second source of relief from the IRS from the potential negative tax consequences of a LIBOR replacement comes in the form of Rev. Proc. 2020-44. This guidance generally protects from a potential reissuance/termination the adoption of one of the protocols provided by the ARRC (for debt) or the International Swaps and Derivatives Association (for hedges – discussed further below). The relief offered is similar to the relief provided in the Proposed Regulations described above, but, for reasons described by the ARRC in its comments to the Proposed Regulations, the ARRC asked the IRS and Treasury to issue separate guidance regarding the ARRC and ISDA protocols and providing that the adoption of those protocols will not result in a reissuance of the affected debt or hedge.

How is all of this playing out in the real world?

One important point here is that the changes that are protected by Rev. Proc. 2020-44 or the Proposed Regulations are intended to become part of the terms of the documents. The general approach of the reissuance rules is that changes that happen pursuant to the terms of the documents or pursuant to the exercise of a “unilateral option” (a term with a specific definition in Reg. 1.1001-3(c)(3)) are not “alterations,” meaning that they do not have to be tested for a reissuance or a termination. However, if in order to effectuate the later transition into a rate or mode that is added as part of the LIBOR replacement process, the parties leave open details that must be negotiated at that time, it increases the possibility that those later decisions will not be protected by the IRS relief and must be tested for a reissuance or termination. That would defeat the whole purpose of the exercise. Issuers and their counsel should carefully study the ARRC and ISDA protocols to ensure that, even if the adoption of the protocol is protected by Rev. Proc. 2020-44 or similar guidance, the later effectuation of the protocol will not require additional changes that might trigger a reissuance of debt or a termination of a hedge.

In addition, more broadly, the practical reality is that the parties to a debt or a hedge, while seeking to transition from LIBOR, may take the opportunity to “tweak” a few other things.[7] Two potentially more complicated situations that we have observed: (1) The parties open negotiations to achieve other business goals and “while they’re at it” will replace existing LIBOR rates with qualified rates. (2) While at first being motivated by the desire to do nothing beyond replace LIBOR rates, “while they’re at it,” the parties will revisit other provisions. These additional changes can complicate the reissuance analysis.

The Proposed Regulations contain a helpful ordering rule[8] that can reduce some of the complications. The Preamble to the Proposed Regulations provides that any alteration to the terms of a debt instrument that is not protected by the “one-sentence” rule from the Proposed Regulations described above[9] is subject to the ordinary operation of the reissuance regulations in Reg. 1.1001-3. The Proposed Regulations provide a similar rule for non-debt contracts. The ordering rule works as follows: When an alteration not protected by the Proposed Regulations occurs at the same time as one or more that are protected, then the protected alterations are treated as part of the existing terms of the debt or hedge immediately prior to the alterations that are not protected. Consequently, the protected alterations become part of the baseline against which the unprotected alterations are tested.

Many (if not most) variable rate financings completed since the announcement of the demise of LIBOR have built in alternative rate mechanisms that vary from identifying a particular replacement benchmark rate to the more prevalent approach of allowing one party (i.e. the lender) to determine a substitute benchmark rate of its choosing (within certain parameters).

Last fall, the International Swaps and Derivatives Association (ISDA) published a new protocol intended to facilitate the transition from LIBOR (and other interbank offered rates) in outstanding derivative agreements.  An ISDA protocol is an amendment mechanism under which counterparties may individually agree to amend their derivative contracts by “adhering” to the protocol. If both counterparties to a particular transaction adhere, then the derivative agreement between those parties is effectively amended without direct negotiation between the parties.  The new ISDA protocol incorporates a new “fall back rate” mechanism in the event a benchmark rate is no longer available or is deemed to no longer be representative.  For U.S. dollar LIBOR rates, the fall back rate is based upon the Secured Overnight Financing Rate (SOFR). This ISDA protocol became effective January 21, 2021.  By signing up to adhere to this new protocol, counterparties are agreeing to an amendment to the existing derivative agreement to incorporate the new fall back rate provisions. As noted above, issuers that adopt the new ISDA protocol should be protected by the terms of Rev. Proc. 2020-44.

On March 24, 2021, the New York Legislature passed legislation aimed at easing the transition from LIBOR.  The legislation provides a safe harbor for lenders, counterparties, trustee banks, and others to select SOFR as an alternative benchmark rate in contracts that do not otherwise provide an alternative rate not based upon LIBOR or leave it to one party’s discretion to select an alternative rate.  The New York legislation, which was signed by the New York Governor and became effective April 7, 2021, applies only to contracts governed by New York law, but a significant number of financial contracts provide for New York law to apply, regardless of the jurisdiction of the contracting parties.  Note that if the added language gives the lender the option to later select an alternative rate, that change likely would need to be tested to determine whether it is a “unilateral option” under Reg. 1.1001-3. If it is not, then the change would need to be tested to determine whether it results in a reissuance,

Plenty more to come on this, but that’s the current update.

[1] Sic.

[2] To our younger readers: ask your parents.

[3] No pun intended.

[4] Prop. Reg. 1.1001-6(g).

[5] This is not a quote from the regulations. We are exercising Sandy’s inherent authority as past President of NABL to quote herself.

[6] And in a governmental bond context, they never would be.

[7] Working title: The Lay’s Potato Chip Effect.

[8] Prop. Reg. 1.1001-6(a)(4).

[9] “An alteration to replace a rate referencing LIBOR with a qualified rate and any associated alteration are not treated as modifications.”