The advent of a new calendar year means many things. For municipalities with outstanding bank loans or interest rate swaps, 2020 may be the year when many first hear about the long-planned phase-out of the London Interbank Offered Rate (“LIBOR”).
Don’t feel bad if you haven’t heard about the LIBOR phase-out, or even if you don’t know what LIBOR is. LIBOR is a benchmark interest rate used globally by financial institutions to set interest rates in loan documents. In the United States, LIBOR is used for nearly all commercial and consumer financial products, ranging from mortgages to student loans. It is also routinely used to set interest rates on municipal debt obligations, and related interest rate swaps. In fact, it is estimated that trillions of dollars of transactions are based, in whole or in part, on LIBOR.
In July 2017, the U.K. Financial Conduct Authority, the regulator of LIBOR, announced that all currency and term variants of LIBOR, including U.S. Dollar LIBOR (“USD LIBOR”), may be phased-out by the end of 2021. Consequently, the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee (“ARRC”) to identify potential alternative rates.
In March 2018, the ARRC published a report summarizing the work done to select the Secured Overnight Financing Rate (“SOFR”) as the replacement rate for the USD LIBOR. Shortly thereafter, the Federal Reserve Bank of New York began publishing SOFR. SOFR is based on overnight transactions in the U.S. Dollar Treasury repo market, which is said to be the largest rates market at a given maturity in the world. SOFR was selected by the ARRC as the replacement rate because it is based on observable transactions in the market. It is said to be transparent, nearly risk-free, and unlike LIBOR, extremely difficult to manipulate or influence.
Since the 2017 announcement, financial institutions, both big and small, have contemplated fallback provisions in anticipation of the elimination of LIBOR that will provide a methodology for replacing LIBOR when it becomes unreliable or ceases to exist. Agreements that include these “fallback provisions” generally will not need to be altered upon LIBOR’s cessation.
However, amendments will be necessary for any agreement that does not contain adequate fallback provisions and matures after 2021. Generally speaking, if a municipality has loans or interest rate swaps on its books from before 2017, they should be examined to determine whether amendments are necessary.
According to the ARRC, these amendments will likely take one of two forms. First, the parties might alter the instruments to immediately replace LIBOR with another rate, most likely based on SOFR. Second, the parties may alter the instruments to replace a fallback rate based on LIBOR with another fallback rate (again, most likely based on SOFR).
For municipalities with outstanding bank loans or interest rate swaps based on LIBOR, a critical concern has been the tax implications associated with these amendments. Municipal debt obligations are generally issued on a tax-exempt basis. When changes are made to a tax-exempt debt instrument, those changes may trigger a “reissuance” of the obligation for tax purposes, if those changes to the instrument constitute a “significant modification” under Treasury Regulation Section 1.1001-3 (the “Reissuance Regulations”).
Under the Reissuance Regulations, a modification of a debt instrument occurs with any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or a holder of a debt instrument, whether the alteration is evidenced by an express agreement (oral or written), conduct of the parties, or otherwise. A modification generally does not include an alteration of a legal right or obligation that occurs by operation of the terms of a debt instrument. A modification is only “significant” if, based on all facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically significant. The Reissuance Regulations provide that a significant modification of an agreement generally results in a sale or exchange of the agreement, meaning, the agreement prior to the modification is deemed to be exchanged for a new agreement. This “reissuance” has a number of federal tax implications. For tax-exempt instruments in particular, a reissuance is treated as the issuance of a new refunding series, which must be judged according to current federal tax law and not the federal tax law in place at the time of the original issuance.
Since the announcement of the phase-out of LIBOR in 2017, the municipal bond industry has eagerly awaited the announcement of guidance from the Internal Revenue Service on the question of the application of the Reissuance Regulations to the LIBOR phase-out. In October 2019, the Internal Revenue Service responded, publishing proposed regulations that provide guidance on the tax consequences of the LIBOR phase-out (the “Proposed Regulations”) (REG-118784-18). The Proposed Regulations address specific concerns that amendments which replace a LIBOR rate, like those amendments described above, will be seen as a “significant modification” under the Reissuance Regulations.
The Proposed Regulations have generally been received favorably by the municipal bond industry, as they provide parties with a roadmap to avoid a reissuance in light of the LIBOR phase-out. According to the Proposed Regulations, changes to a debt instrument, interest rate swap or other affected contract, that replace a rate referencing any interbank offered rate (which includes LIBOR) with a “qualified rate,” and any associated alteration or modification, will not result in a reissuance under the Reissuance Regulations. Thus, a reissuance will not occur if the parties replace LIBOR with a “qualified rate”.
A “qualified rate” includes several enumerated rates, including SOFR, as well as any alternative rate that is selected, endorsed or recommended by the central bank, reserve bank or any similar institution, provided, in each case, that the rate be substantially equivalent in fair market value to the replaced rate (the “Fair Market Value Test”) and generally based on the same currency (the “Currency Test”).
The Proposed Regulations provide two safe harbors to assist parties in satisfying the Fair Market Value Test. Under the first safe harbor, the Fair Market Value Test is satisfied if, at the time of the alteration or modification, the historic average of LIBOR is within 25 basis points of the historic average of the rate that replaces it. For purposes of the first safe harbor, parties may generally use any reasonable method to compute the historic average, subject to the limitations described in the Proposed Regulations. Under the second safe harbor, parties to an agreement may not be related and the parties must determine, based on a bona fide, arm’s length negotiation, that the fair market value of the altered agreement is substantially equivalent to the fair market value of the agreement before the alteration or modification. In determining the fair market value of the altered agreement, the parties must take into account the value of any one-time payment made in lieu of a spread adjustment. Parties have the option of selecting either safe harbor in showing compliance with the Fair Market Value Test.
In addition to satisfying the Fair Market Value Test, a qualified rate must also satisfy the Currency Test. Under the Currency Test, the replacement rate must be benchmarked to transactions in the same currency as the currency benchmark for LIBOR. The intent of this requirement, like the intent for the Fair Market Value Test, is to ensure that alterations or modifications are no broader than necessary to address the elimination of LIBOR.
The Proposed Regulations also recognize that associated alterations may be necessary when amending or modifying an agreement to replace a LIBOR rate. Under the Proposed Regulations, these “associated alternations” do not result in a reissuance under the Reissuance Regulations if the alterations were associated with the replacement of LIBOR and reasonably necessary to adopt or implement the replacement rate.
Interested parties were invited to submit written comments on the Proposed Regulations through November 25, 2019. Although final regulations have yet to be issued, parties may begin relying on the Proposed Regulations for alterations and modifications of their agreements, provided, that parties consistently apply the rules of the Proposed Regulations.
With LIBOR’s phase-out quickly approaching, municipalities should review their existing loans and related interest rate swaps to determine whether amendments are necessary. The attorneys of the Public Finance and Government Services Group at McNees Wallace & Nurick LLC will continue to monitor the status of the LIBOR phase-out. For specific questions about the Proposed Regulations, and its application to current agreements, contact attorneys Timothy Horstmann or Erica Wible.
Reprinted with permission from the February 19, 2019 edition of The Legal Intelligencer © 2020 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.