LIBOR – What to do Now

New York Wednesday, November 28, 2018 History of LIBOR and the Transition Away From LIBOR

Stuart M. Litwin Co-Head, Structured Finance Practice [email protected] +1 312 701 7373 + 1 212 506 2389 Brief History

• When I first started practicing law in the 1980s, LIBOR often really was match funded – Fallback provisions in loan agreements and indentures were originally designed to deal with short-term disruption in the LIBOR market – They were never intended to address a situation where LIBOR may disappear forever • The setting of LIBOR was managed by the British Bankers Association (“BBA”). Each business day the BBA calculated the rates based on submissions by individual panel banks for each applicable currency • Starting in 2012, there were allegations of misconduct in the setting of LIBOR • In 2013, U.K. Financial Conduct Authority (“UK FCA”) selected Intercontinental Exchange Group (“ICE”) to be the LIBOR administrator – Goal of this transfer was to bring more transparency and oversight to the calculation of LIBOR

3 What Is The Current Problem With Libor?

• There has been a continued decline in the degree to which banks fund themselves in the London interbank market • As that decline continues, U.S. (and other) regulators are concerned there will be insufficient trading volume and liquidity to support the use of LIBOR as a benchmark interest rate • Quotations used by ICE today to calculate ICE LIBOR are not based on actual transactions, but “expert judgment.” • UK FCA reported in late 2017 that all LIBOR panel banks have agreed to continue to supply quotations through the end of 2021 – UK FCA will no longer require LIBOR submissions after 2021 • Other Problems with LIBOR – Pending and potential litigation – LIBOR spreads have widened compared to other benchmarks

4 Why LIBOR Matters

• LIBOR stands for London interbank offered rate – Interest rate at which banks offer to lend funds to one another in the international interbank market – LIBOR was designed to reflect how much it costs banks to borrow from each other in specified currencies for specified periods of time • LIBOR is the benchmark reference for determining interest rates for a multitude of debt and derivative instruments – It is also used as a benchmark rate for mortgages, corporate loans, government bonds and a myriad of structured finance instruments • Combined exposure for various asset classes that rely on LIBOR exceeds $199 trillion – Derivatives are $190 trillion of this 5 U.S. Regulators Response

• Federal Reserve Board and the Federal Reserve Bank of New York convened a joint committee (Alternative Reference Rates Committee – the “ARRC”) to identify a replacement rate • Committee wanted a “risk-free” rate – a theoretical rate of return on an investment with no risk of financial loss • The ARRC identified the Secured Overnight Financial Rate (“SOFR”), which is the cost of overnight loans that use U.S. government obligations as collateral

6 LIBOR vs SOFR Issues

• Participants in the lending and securities markets have raised objections to SOFR

– SOFR is a risk free rate, LIBOR is not, so SOFR likely will be a lower rate than LIBOR

• LIBOR widens in periods of stress; SOFR likely will not

• SOFR is likely more volatile at quarter end

– SOFR is an overnight rate, and changes daily. LIBOR is typically quoted for 1 or 3 months

• Need a term rate

• Compounding vs a simple average – ISDA plans to create fallbacks based on both

• Market participants are generally assuming that market forces will develop into a “one month SOFR rate” and a “three month SOFR rate

– SOFR is backward looking. LIBOR is forward looking. Need to be able to set a rate for the next period

– Probably will need spread adjustments if we move to SOFR

• Static adjustment on conversion date or dynamic adjustment that reflects changes in spreads between SOFR and other LIBOR equivalents?

– Will there be any effects on ratings in a shift to SOFR? For example, are past LIBOR assumptions correct for volatility and basis risk for underlying assets?

• Fed believes that SOFR will be less volatile than LIBOR

• Need CFTC and IRS regulatory help to grandfather legacy deals and avoid having amendments trigger clearing and margin, tax recognition

• Do you no longer have hedge accounting if only one of your assets or your hedge changes its benchmark, or they don’t change precisely together?

7 LIBOR vs SOFR Issues

• In response to concerns raised by participants in the loan markets, in November 2017 the ARRC announced:

– Its membership would be expanded to include participants in the cash market (corporate loans, mortgage loans, securitizations, etc.)

• LSTA, SIFMA and SFIG are now members

– It would work to develop a SOFR-based rate that is forward-looking and is a term rate

• But that rate would still be risk-free (and therefore lower than LIBOR)

• That rate wouldn’t be introduced until after there was enough experience using SOFR in the derivatives market

– ARRC originally estimated date would be Q2 of 2021 (!)

– In March 2018, ARRC instead promised the rate by the end of 2021

– The Committee said it might have a “demonstration” rate before then

8 Changes to LIBOR Before 2021

• Changes to LIBOR (April 25, 2018 paper by ICE Benchmark Administration) – ICE will transition to a “Waterfall methodology,” in which panel banks provide quotations in the following order of priority.

• Level 1: Transaction-based • Level 2: Transaction-derived (can use historical data and linear interpolation) • Level 3: Expert judgment

– Will be complete by the first quarter of 2019 – Not clear whether LIBOR quotes will indicate whether they are primarily Level 1, 2 or 3

9 Recent Developments

• The Federal Reserve Bank of New York began publishing the SOFR rate every day since April 2018 – Calculation of SOFR appears very much to be a black box • Fannie Mae’s and MetLife’s SOFR transactions • SFIG is working on a “Green Paper” that highlights important issues and suggests some possible model language for structured finance deals

10 What Will Happen to LIBOR After 2021?

• Continued use of LIBOR even after 2021:

• Some market talk about keeping LIBOR

• Could be done by ICE (which is certainly motivated to continue to publish LIBOR rates), assuming that banks will continue to supply LIBOR quotations after 2021

– ICE Benchmark Administration wants to publish LIBOR rates after 2021 – “alongside the alternative risk-free rates that are being developed”

– No guarantee that LIBOR will continue to be published – requires voluntary support from the banking industry

– Efforts by ICE to get licensing fees

• Could be done by a new non-European private sector source

– U.S. regulators have expressed a preference for a rate published by the public sector

– Need to comply with the EU Benchmarks Regulation

• BUT the Fed is adamantly against any use of any LIBOR type rate

– Fed says it’s an unstable rate that poses systemic risks

– Might still be helpful for Legacy Transactions 11 Legacy Deals

• Remember that most fall-back provisions in existing loan agreements and indentures were originally designed to deal with short-term disruption in the LIBOR market

– These provisions never were intended to address a situation where LIBOR may disappear forever

• Types of fallback provisions:

– Often there’s a “waterfall”:

• First look at a screen or publisher (e.g., Bloomberg, Reuters, Telerate, Wall Street Journal) ceases to publish the applicable LIBOR

• If the screen rate is “not available,” get quotes from a group of reference banks in the London interbank market

• If that doesn’t work

– Loans often use prime - prime is significantly more expensive than LIBOR, so borrowers won’t accept this on a long term basis

– Sometimes loans use a lender’s cost of funds rate. Lenders don’t want to disclose their cost of funds or get into disputes about it

– Securities transactions often use the last LIBOR quote (if LIBOR is gone forever, this results in a fixed rate deal)

12 Legacy Deals

• Two issues in legacy transactions: – When has LIBOR become “unavailable”? – What happens next? • When has LIBOR become “unavailable”? – What if there is still a quote on the screen? • ICE says it plans to continue to quote LIBOR, but it won’t be based on real transactions – “Zombie LIBOR” • What if banks continue to quote LIBOR, but not based on real transactions – This is the same as the securities markets for thinly traded securities • How difficult will it be for trustees to get quotes? Will they do so? – Probably the most likely bit of trustee litigation – ICE efforts to collect licensing fees from users

13 Legacy Deals – Amending?

• Amending the LIBOR definition – Some deals just have a “Rating Agency Condition” – Some have a “no adverse effect” or “no material adverse effect” standard, often with a legal opinion – Lots of deals can’t be amended without unanimous consent

14 Legacy Deals

• Do investors have much incentive to push for a different benchmark in legacy deals? Would they approve an amendment? – It’s economically good for investors if LIBOR spreads widen. LIBOR spread over overnight swaps has widened in recent months – It’s terrible if interests rates increase but their deals convert to a fixed rate • Is this going to be a “Train Wreck”?

15 Who will get hurt in Legacy Deals?

• Trustees are in the worst position • Sponsors will want to try to amend when they can – Does it make sense to wait until there’s actually a problem?

16 Basic Issues in New Deals

• What is the “trigger” that requires or permits a new benchmark rate? • What benchmark rate will be selected? • Spread adjustments • How to assure investors aren’t harmed • Who makes the decisions?

17 Some Questions About Spread Adjustments

• Static? • Dynamic? • Only transitional? • Different for different Lenders? – In syndicated loans, will all lenders require approval?

– Will borrowers get to approve? • Will investors in securities transactions get to approve? – Not really practical – Can they have a right to object? Difficult to decide what happens then.

18 What’s Happening Now

• Bargaining power is the most significant determining factor • Banks are adding LIBOR replacement language at every renewal/new loan – In syndicated loans, goal is to avoid chaos that could be the result of unanimous voting requirements • Changes in pricing are typically 100% issues in syndicated credit facilities – In bilateral transactions, the bank tends to give itself discretion – “Category 1” companies will have approval rights or greater control as a practical matter • In securities transactions, “Category 1” companies are starting to provide for their own discretion – Other companies are more hesitant about making changes to their deals

19 Conclusions

• It is likely that LIBOR, as we now know it and have historically known it, will cease to be the universally-used base rate for derivative, structured finance and syndicated loan transactions.

• The U.S. authorities have identified a preferred replacement benchmark rate (the Secured Overnight Financing Rate or SOFR) for derivative and other transactions.

• A forward term rate will be introduced, but perhaps not until 2021. Will that be too late?

• At this time it is unclear what adjustments and financial markets would be necessary to adapt SOFR (or create an alternate rate) that would be better suited to derivative, structured finance and syndicated lending transactions.

• It is probably premature to try to incorporate a new benchmark rate and spread adjustments into credit documentation and new securities offerings. We just don’t have a good enough crystal ball.

• Over the next months and years the credit markets will develop an approach (or approaches) for documenting the replacement of LIBOR with a new benchmark rate.

20 QUESTIONS Practical Advice for New Deals

Curtis A. Doty John A. Janicik Partner Partner [email protected] [email protected] +1 212 506 2224 +1 312 701 7323 Barbara M. Goodstein Stuart M. Litwin Anna T. Pinedo Partner Partner Partner [email protected] [email protected] [email protected] +1 212 506 2264 +1 312 701 7373 +1 212 506 2275 HOW DERIVATIVES FIT INTO THE PICTURE Overnight, Term and Forward-Looking Term Rates

• USD-SOFR-COMPOUND (Supplement 57 to 2006 ISDA Definitions) – Compounded (i.e., geometrical) average of SOFR for each U.S. Government Securities Business Day in the Calculation Period – Not known with certainty until after the last USGSBD of the Calculation Period • SOFR Overnight Index Swap (OIS) Rate (as defined in FASB ASU 2018-16): “The fixed rate on a U.S. dollar, constant-notional interest rate swap that has its variable-rate leg referenced to SOFR (an overnight rate) with no additional spread over SOFR on that variable-rate leg. That fixed rate is the derived rate that would result in the swap having a zero fair value at inception…” The Fundamental Conundrum of IBOR Transition

• Some users of non-derivative products (e.g., loans) may have a strong preference for forward-looking term rates, but… • In derivatives markets, the bulk of liquidity needs to be in the RFRs, not FLTRs. Otherwise, in regulators’ view, we’ll have reproduced the original problem with IBORs – a thinly traded benchmark supporting a massive superstructure – See FSB, Interest rate benchmark reform – overnight risk-free rates and term rates (July 2018) – ISDA consultation on IBOR fallbacks does not include FLTRs among the choices for an adjusted RFR ISDA Consultation on IBOR Fallbacks for 2006 ISDA Definitions (July 2018)

• Under planned amendments, floating rate options will be revised to include fallbacks that will be triggered upon the permanent discontinuation of the related IBORs, as evidenced by a public statement by the administrator of the IBOR or the administrator's regulatory supervisor • The consultation sought market input on methods for term and credit spread adjustments to risk-free rates for use in IBOR fallbacks. Preliminary results were announced on November 27 • Preliminarily and subject to the ultimate board committee decision, ISDA expects to develop fallbacks based on a compounded setting in arrears rate and the historical mean/median approach to the spread adjustment for all of the benchmarks covered in the consultation • Although USD LIBOR was not covered, preliminary feedback indicates that the compounded setting in arrears rate and the historical mean/median approach to the spread adjustment may also be appropriate for USD LIBOR Some Elements of the ARRC Transition Timeline (as of 10/30/18)

• EOY 2018/Q1 2019 – ARRC is seeking to produce an indicative SOFR-based term reference rate based on futures data to help promote market familiarity • Q1 2020 – CCPs to begin allowing a choice to clear new or modified swap contracts using SOFR for price alignment interest (PAI) and discounting (As of 10/30/18, SOFR PAI/discounting offered only for SOFR cleared swaps) • EOY 2021 – create a forward-looking SOFR term rate How Crucial Are FLTRs for Non-Derivative Products?

• Advance visibility for cash-planning purposes, but… – In securitization and structured deals, payments are subject to a waterfall – Compounded setting-in-arrears SOFR can be hedged to a fixed rate by entering into an overnight index swap (i.e., where the floating rate is USD- SOFR-COMPOUND) – See data on historical differences between 3-month OIS rate and ex post compounded setting-in-arrears for effective federal funds rate, available at https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2018/Thou ghts-on-ISDA-Methodologies.pdf Practical Questions

• Tolerance for basis risk if the hedged instrument is (or becomes) FLTR-based but swap market liquidity centers on arrears-setting SOFR OIS, or if the transition triggers for the cash instrument and the hedge are not concurrent? • How are hedging covenants drafted? Are they flexible enough to permit, e.g., hedging LIBOR with SOFR OIS, or FLTR with SOFR OIS? • Conduct risk for dealers – disclosure of pricing methodology, material risks • Consensual close-out and rebooking in advance of 2021. When will the LIBOR forward curve cease to be a robust mechanism for pricing early termination? • Cross-currency hedges – different transition dates for different legs Regulatory Issues under Dodd-Frank Title VII

• Compliance burden and economic costs if amendments to include fallbacks or replace rate trigger the application of regulatory requirements – Loss of grandfathered status under uncleared margin and (if CFTC extends mandates to SOFR) clearing and trade execution? – Triggering of swap dealer business conduct rules – Swap trading relationship documentation, confirmations – Real-time reporting – Swap data reporting, portfolio reconciliation • See ARRC Title VII Letter to U.S. regulators (July 2018) QUESTIONS LIBOR Transition: Litigation Risks and Strategies

Christopher J. Houpt Sagi Tamir Partner Partner [email protected] [email protected] +1 212 506 2380 +1 212 506 2583 Matthew D. Ingber Partner [email protected] +1 212 506 2373 Background and Origins of Uncertainty

• LIBOR used in variety of existing transactions – Loans – Structured finance – Derivatives • Legacy transactions will continue beyond 2021 • Two sources of uncertainty – When will LIBOR become “unavailable”? – What should replace it in a particular transaction?

33 Litigation Risks and Considerations

• When to stop using LIBOR? – the “Discontinuance Event” – Depends on the definition in the specific contract

• LIBOR as published by ICE (or BBA)

• LIBOR as reported on Reuters/Bloomberg/WSJ – “Zombie” LIBOR may continue to be published even after submissions cease to be mandatory – Some contracts identify specific data sources that may continue to report numbers

• Some contracts expressly refer to “successors” to those data sources

34 Litigation Risks and Considerations

• What to use instead of LIBOR? – Fallbacks exist in many contracts but are unsatisfactory

• Most meant for temporary unavailability

• Last-available LIBOR—would transform floating rates into fixed rate

• Private polling of banks—impracticable as a permanent solution – But, on their face, these contracts provide direction – Source of dispute—follow a clear, but impractical, fallback?

• Impossibility

• Frustration of purpose

• Mutual mistake 35 Litigation Risks and Considerations

• Sources of loss – Difference in interest – Volatility, correlations

– Basis risk

• Broken hedges

• Asset/liability management

36 Litigation Risks and Considerations

• Factors affecting litigation risk – Number of parties – Concentration of interest rate exposure – Investor constituencies

37 Litigation Risks and Considerations

• Litigation scenarios – Borrower vs lender (or agent)

• Trust Indenture Act section 316(b) – Lender/investor vs agent/trustee

• Disputes over amendments

• Role of administrative parties – Client vs advisor – Investor vs underwriter – Anticipatory declaratory judgment suits

38 Strategies to Address Risks and Likely Disputes

• Act early and in advance of transition – Evaluate LIBOR definition, fallback provisions, and amendment process – Identify all potentially affected parties, including those to related hedges – Commence dialogue to assess varying positions and identify both possible disputes and amicable resolutions • Consider mechanisms to resolve potential disputes – Pre-transition amendments, if possible, will avoid more complicated disputes post-transition – Declaratory judgment actions may permit resolution of disagreement in advance 39 Strategies to Address Risks and Likely Disputes

• Contract amendments may be difficulty in multi-party transactions – Changes to interest rate often require unanimous consent

40 Trustee-Specific Issues

• Transition could require trustees to make hard decisions – May have to select alternate rate; interpret ambiguous language; or follow clear language not intended to apply – Might also be asked to approve or accept proposed replacement rates by issuers and/or swap counterparties • Trustee’s role makes litigation a distinct possibility – Trustees may be eligible to institute judicial instruction proceedings to limit their exposure

41 QUESTIONS Mayer Brown is a global legal services provider comprising legal practices that are separate entities (the "Mayer Brown Practices"). The Mayer Brown Practices are: Mayer Brown LLP and Mayer Brown Europe-Brussels LLP, both limited liability partnerships established in Illinois USA; Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales (authorized and regulated by the Solicitors Regulation Authority and registered in England and Wales number OC 303359); Mayer Brown, a SELAS established in France; Mayer Brown JSM, a Hong Kong partnership and its associated legal practices in Asia; and Tauil & Chequer Advogados, a Brazilian law partnership with which Mayer Brown is associated. Mayer Brown Consulting (Singapore) Pte. Ltd and its subsidiary, which are affiliated with Mayer Brown, provide customs and trade advisory and consultancy services, not legal services. "Mayer Brown" and the Mayer Brown logo are the trademarks of the Mayer Brown Practices in their respective jurisdictions.