A Long Hot Summer: Effective Variable Rates Subject to Increase (Irrespective of General Market Conditions)

This is the first in a series of client alerts discussing the ramifications of the phaseout of USD LIBOR on variable rate transactions. 

Inadequate Fallbacks (Despite Legislation)

On July 1, 2023, LIBOR will no longer be published. Congress and the Board of Governors of the Federal Reserve System had sought to fill in the gap through legislation and rules that provide fallback benchmark rates. 

While these laws apply to many instruments, they are inapplicable to two large subsets of variable rate debt: municipal notes and bonds, and privately placed securities, whether issued by municipalities or companies. 

For these financings, guidance on which post-LIBOR benchmark to use is described in the indenture. However, many indentures provide no real fallback should LIBOR become unavailable long-term. This means, subsequent to LIBOR’s phaseout, many issuers and holders will find that they diverge on what should be the new applicable interest rates, leaving trustees torn on how best to proceed. 

Variable Rate Primer

Sacrosanct Terms

Every bond (and note) indenture has three key terms that are sacrosanct: the principal amount issued, the maturity date, and the interest rate (for variable rate deals, the method for calculating interest, including the use of appropriate benchmarks). Changing any of these three sacred terms typically requires unanimous consent by holders. 

Variable Rate Rationale

Variable rate transactions have interest rates that are subject to change at regular intervals at the end of an applicable “reset” period, with rates increasing or decreasing to, ostensibly, keep the rates in line with market fluctuations. Variable rate deals are attractive to issuers, in particular municipal governmental issuers, because variable rates tend to be lower than fixed rates.  However, in the event the market shifts and rates increase, variable rates deals will have a corresponding increase when the rates reset. 

In contrast, fixed rate deals remain unchanged during the term of the transaction, with the fixed rate initially determined to take into account expected future rate fluctuations.  

Variable Rate Risks

Despite the attractiveness of lower rates, variable rate transactions carry increased risk to issuers should rates increase, as well as the risk of a failed remarketing. As the reader is well aware, interest rates have increased significantly over the past 15 months, unparalleled since the 1980s.

Therefore, risk-adverse issuers, generally obtain interest rate swaps (or caps) in conjunction with these deals to provide protection against variable rate fluctuations. 

Swap Risks

Swaps permit governmental (and other) issuers to hedge the risks associated with the variable rates of their notes and bonds. However, there are also significant risks associated with swaps, including, among others, basis, counterparty, collateral, and termination risks, as well as potential mismatching of the provisions of the indentures and the swaps.

In a subsequent alert, the hedging relationship between variable rate debt and swaps will be explored, as this relationship will be significantly impacted by the LIBOR phaseout. 

The LIBOR Phaseout

As previously mentioned, on July 1, 2023, LIBOR tenors will no longer be published. Consequently, financial instruments pegged to LIBOR must utilize different benchmarks when reset after the LIBOR end date. 

Rationale

The move from LIBOR emanates from regulators’ increasing disapproval of LIBOR over the past decade. This disfavored view of LIBOR was precipitated by the 2012 revelations that major banks were manipulating LIBOR rates for profit and to telegraph to the markets that the banks were in better financial condition than they actually were during the Great Recession. 

In response, regulators across the globe conducted investigations, leading to billions of dollars of settlements with regulators. In the United Kingdom, the trade association for the UK banking and financial services sector that had been responsible for calculating LIBOR was replaced, and the governmental regulator of LIBOR was disbanded and replaced with the UK Financial Conduct Authority (UK FCA).

The regulators are now requiring the move away from LIBOR’s subjective index as determined by international banks. The hope is that the new benchmarks will be subject to less manipulation in the future.

Remaining Legacy Debt

As we previously reported in an alert on March 8, the transition away from LIBOR has been turbulent, and despite effectively years’ worth of notice since the UK FCA first announced the phaseout in 2017 (and more than 10 years since the scandal erupted), many contracts remain pegged to LIBOR without a replacement rate. As of February 24, 2023, S&P Global Inc. estimates that about 75% of leveraged loans and about 85% of rated US collateralized loan obligation (CLO) liabilities were still indexed to LIBOR. It has been estimated that trillions of dollars of legacy debt is tied to LIBOR that has yet to transition to alternative benchmarks.

Federal Law to the Rescue?

General

Last year, the Federal government stepped in to provide paths forward for many financial instruments that remain indexed to LIBOR. On March 15, 2022, President Biden signed the Adjustable Interest Rate Act (the LIBOR Act)[1] into law. The LIBOR Act applies to “any contract, agreement, indenture… that, by its terms, continues in any way to use LIBOR as a Benchmark as of [June 30, 2023].” It further provides that a benchmark replacement selected by the Federal Reserve’s Board plus a tenor spread adjustment will apply on that date, and that any provisions in contracts providing a fallback to a LIBOR rate shall be disregarded.  

The Board published its final rule (the Board Rule) implementing the LIBOR Act on January 26, 2023.[2] The Board Rule established that non-derivative contracts pegged to LIBOR would for (1) contracts pegged to the overnight LIBOR tenor, switch to the Secured Overnight Financing Rate or “Daily Simple SOFR”, plus a small tenor spread adjustment to make up for the difference between LIBOR and Daily Simple SOFR; or (2) contracts pegged to 1-month-, 3-month, 6-month or 12-month tenors of LIBOR, switch to “Term SOFR” plus the corresponding spread adjustments. 

The International Swaps and Derivatives Association (ISDA) determined these spread adjustments in March 2021 (more than two years before phaseout), ranging from 11 to 72 basis points for the non-overnight tenors. “Daily Simple SOFR” is published by the Federal Reserve Bank of New York and “Term SOFR” is a proprietary benchmark administered by CME Group Benchmark Administration, Ltd.

We will expand upon on the differences between Daily Simple SOFR and Term SOFR in a future alert.

Trust Indenture Act

Importantly, the LIBOR Act provides a safe harbor for any parties that utilize the Board’s benchmark replacement. Notwithstanding the general rule that holder consent is required to modify the three sacred rights mentioned above (principal, maturity, and interest rate), the LIBOR Act amends the Trust Indenture Act of 1939 (the Trust Indenture Act)[3] to provide that holder consent is not needed for any change in interest rates on their notes and bonds that occurs through implementation of the LIBOR Act. The LIBOR Act does not require that deal parties utilize the benchmark replacement if holders agree to a different benchmark. Nonetheless, in the absence of such an agreement, the LIBOR Act provides the de facto fallback.

But Certain Debt Inapplicable

The Trust Indenture Act does not, however, apply to municipal securities and private placements, whether corporate or municipal. As a result, the LIBOR Act’s holder consent carve-out does not apply to these deals and, without holder consent, the LIBOR Act’s switch to the Board benchmark replacement does not effect a change in benchmarks for municipal and privately placed notes and bonds (the Non-LIBOR Act Debt).

Replacement Benchmarks for Non-LIBOR Act Indentures

While the federal government has made significant progress toward establishing a transition for contracts tied to LIBOR, none of these statutes or rules change the status quo for Non-LIBOR Act Debt deals, even though many of those financings utilize some sort of LIBOR-based rate. We reviewed several indentures governing Non-LIBOR Act Debt to gain an idea of the types of LIBOR fallbacks provided for in such deals and a view of what might happen to such deals after the LIBOR phaseout. 

Based on our non-scientific survey, LIBOR-based variable rate indentures for Non-LIBOR Act Debt tend to fall into three categories:

Clear Fallbacks 

These indentures provide a fallback to an alternative interest rate benchmarks that would function in perpetuity once LIBOR is phased out. For example, the indenture’s language may clearly contemplate a situation where LIBOR can no longer be used and provides another published interest rate to fall back on. Some alternative benchmarks used in the indentures we reviewed include, for example, the Prime Rate[4], the Federal Funds Rate[5], the higher of the two, or a formula based on the SIFMA index[6]. Recent indentures, and recently amended indentures, defer to the replacement benchmark rate designated by the Federal Reserve-established Alternative Reference Rates Committee (ARRC), which happens to be Term SOFR. Because these indentures have clear fallbacks, they will not face as much uncertainty come July. 

That said, holders under those indentures who do not know that their notes and bonds will not transition as contemplated under the LIBOR Act, which will automatically switch to another benchmark in July, may find that their debt suddenly has materially higher interest rates as a result of the transition from LIBOR upon reset.

Weak Fallbacks

There are other indentures that establish fallbacks but do not provide an adequate long-term replacement. These indentures generally contemplate temporary disruptions in LIBOR but not a complete phaseout.  For example, some indentures simply reuse the previous reset period’s interest rate. As a result of LIBOR’s phaseout, this could have the effect of turning the variable rate into a fixed rate as these indentures do not provide a mechanism to update the rate after that point (except upon tender or by unanimous consent of holders). Moreover, the impending LIBOR phaseout of trillions of dollars of debt may lead to artificially elevated LIBOR rates in the leadup to June 30, which would cause notes/bonds pegged to the last published LIBOR rate to be set indefinitely at a rate that is considerably higher than recent LIBOR rates. 

Other indentures we reviewed rely on a “determining party” named under the indenture (typically, the bank) to generate a replacement for LIBOR following a specified calculation, such as by averaging the interest rates being offered by major banks in London for the relevant period. These replacement methodologies may be feasible for a short-term period where LIBOR is unavailable, but the parties likely did not consider this methodology to be applied through maturity. Holders who bought expecting a regularly changing variable rate will, then, suddenly have a fixed interest rate or will have a bank determining the interest rate ad hoc.

No Fallbacks

These indentures are exposed to the highest level of risk because they do not provide any fallback alternative to LIBOR. At most, these indentures only contemplate a situation where a particular LIBOR publication, such as The Wall Street Journal, Bloomberg, or Reuters, no longer publishes LIBOR, and publication lapses to another source. For some indentures, LIBOR is provided as the fallback when another interest rate benchmark fails. Basically, after the first reset in July, many of these securities will no longer have a published rate available, or might require the issuer, holders, and the trustee to agree to a replacement rate.   

Further Summertime Blues

The federal government has attempted to put rules in place that will determine the next chapter for LIBOR-pegged financial instruments. Unfortunately, these rules do not apply to all financial instruments, and for Non-LIBOR Act Debt, the end of LIBOR may come with no fallback rate to rely on and significant uncertainty going forward. 

These are not the only problems that will be created for variable rate debt as a result of the transition. Among others, parties to debt instruments covered by the LIBOR Act will still need to parse through the complexity of Daily Simple SOFR and Term SOFR and resulting hedging concerns. In subsequent client alerts, we will explore these issues as well as (i) the Hobson’s Choice of alternatives available for Non-LIBOR Act Debt, (ii) the potential consequences for parties to variable rate transactions who fail to act before June 30, (iii) the potential consequences for parties to variable rate transactions who do act before the LIBOR end date but follow ‘industry-standard’ documentation proffered by the banks, (iv) the validity of the Board Rules, and (v) the many dilemmas faced by indenture trustees over this phaseout.

Hope everyone enjoys spring before the first days of summer – starting on June 21!

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[1] Pub. L. 117-103 Div. U (codified at 12 U.S.C. §§ 5801-5807).

[2] Finalization of this rule occurred months after the LIBOR Act’s September 11, 2022, deadline for the Board to adopt these rules.

[3] 53 Stat. 1149-1177 (codified at 15 U.S.C. §§ 77aaa-bbbb).

[4] The Prime Rate is an interest rate set by individual banks as the basis for rates for loans, credit cards, and more.  The Prime Rate is based on the Federal Funds Rate.

[5] The Federal Funds Rate is the volume-weighted median of overnight federal funds transactions.  The New York Fed publishes this rate at https://www.newyorkfed.org/markets/reference-rates/effr.

[6] The Securities Industry and Financial Markets Association  (SIFMA) Municipal Swap Index, is a 7-day index of reset rates for tax-exempt variable rate debt obligations. The index is calculated by Bloomberg and published at https://www.bloomberg.com/quote/MUNIPSA:IND?leadSource=uverify%20wall.