Replacing LIBOR in Indentures

Introduction

In July 2017, the CEO of the U.K. Financial Conduct Authority (FCA), Andrew Bailey, announced that the FCA will discontinue the London interbank offered rate (LIBOR) at the end of 2021. LIBOR is an interest rate index which is currently used in calculating floating or adjustable rates on trillions of dollars in bonds, loans, derivatives and other financial agreements.

A phaseout of LIBOR will be a major undertaking raising many issues, including the selection of a successor rate for new transactions and the fallback rate for existing transactions. Many of these issues remain unresolved for now. Their ultimate outcome will have consequences for both existing floating rate indentures with maturities past 2021 and new indentures that will be negotiated and executed prior to the phase out of LIBOR.

Why LIBOR is being Replaced

The interbank offering rates (IBORs) are floating rates based on the actual or purported interbank offered rates for short-term loans in various currencies and maturities based on daily surveys of major banks. There are IBORs for each major currency (USD-LIBOR/GBP-LIBOR/EUR-EURIBOR/JPY-TIBOR). Following alleged manipulation of LIBOR after the financial crisis, the U.K. government decided to regulate the setting and administration of LIBOR, as well as the submission of rates by banks used to create LIBOR, and placed these activities under the supervision of the FCA.

The alleged manipulation also prompted a review of major financial benchmarks, and in 2014, both the Financial Stability Board (FSB) and the Financial Stability Oversight Council (FSOC) in the U.K. reported concerns over the reliability and robustness of IBORs.¹ The main issues raised by the FSB and the FSOC were the following. The rates that banks report in order for these benchmark rates to be created do not have to be based on actual transactions. And the benchmark rates rely too heavily on transactions in a relatively low-volume market, which increases the potential for manipulation. As a consequence, the FSB recommended that IBORs, and other similar benchmark rates, be determined based to the greatest extent possible on real transaction data. The FSB also recommended the development of alternative nearly risk-free reference rates (RFRs), because counterparty risk, which is accounted for in the IBORs, does not necessarily make sense for many of the transactions using the IBOR benchmarks.

In the U.S., following the FSB recommendations, the Federal Reserve assembled a group of financial institutions representatives known as the Alternative Reference Rates Committee (ARRC) in order to identify alternative, transaction-based reference interest rates to replace USD-LIBOR. In June 2017, ARRC announced that it had identified an overnight “broad Treasuries repo financing rate,” based on transaction-level data from certain tri-party and bilateral repo clearing platforms, as a potential successor to the USD-LIBOR (the RFR Replacement Rate).²

The following month, the FCA announced that despite its efforts to improve the process of setting LIBOR, it had proven difficult to ensure that rates and submissions were linked to actual transactions. The FCA concluded that it was unsustainable for market participants to indefinitely rely on reference rates that are not supported by an active underlying market, and announced that LIBOR would be phased out by the end of 2021.

There will not be a “ban” on LIBOR at the end of 2021, and in fact, LIBOR may still be published after that date by the LIBOR administrator,³ if it can obtain sufficient submissions from major dealers. There is no assurance that this will be the case, however. The FCA has the regulatory power to compel major dealers to provide submissions, although the dealers currently, if reluctantly, provide submissions on a voluntary basis. The FCA has announced that after 2021, it will not use its regulatory power to compel submissions, and given the environment, it is questionable whether the dealers will continue to voluntarily provide the submissions.

Transition to a LIBOR Successor/Fallback Rate

The replacement of LIBOR has direct consequences for derivatives transactions, and in 2016 the International Swaps and Derivatives Association (ISDA) established working groups on the development of alternative risk-free rates and fallbacks. Recently ISDA arranged a webcast to provide an update on the direction taken by its working groups.⁴ Although no consensus has emerged regarding a replacement rate, ISDA confirmed that the current approach (which may change) is to consider the RFR Replacement Rate as the successor/fallback rate for USD-LIBOR. However, since the RFR Replacement Rate is a risk-free rate — which doesn’t take into account the bank credit risk reflected in LIBOR — and is also an overnight rate — whereas LIBOR has different rates for specified tenors — there exists a concern that a significant value transfer would occur for existing transactions upon switching from USD-LIBOR to the RFR Replacement Rate. The ISDA working groups are currently discussing solutions to address these and many other issues.

While ISDA working groups are active in the context of derivatives, the issues they are grappling with are also relevant to floating rate note indentures, and the work conducted by ISDA working groups could influence the selection of a consensus successor to LIBOR in the indenture context as well.

LIBOR Successor/Fallback Rate in Existing Indentures

In existing indentures, the standard fallback mechanism is very similar to the standard mechanism for derivatives. Typically in indentures, if LIBOR is unavailable, the fallback rate will be determined by the calculation agent based on rates at which U.S. dollar deposits are offered by major banks to prime banks in the London interbank market for the relevant interest period. If at least two quotations are provided, the arithmetic mean is used. If fewer than two rates are provided, then the rate for the immediately preceding interest period continues in effect.

The rate resulting from this standard fallback mechanism, if used as a permanent replacement for LIBOR in floating rate indentures after 2021, could differ substantially from a new benchmark rate (such as the RFR Replacement Rate), could create uncertainty and inconsistencies in the financial markets, and may generally be unsatisfying for noteholders. 

In derivatives transactions, the fallback mechanism can be changed as long as both parties to the agreement agree to amend the transaction.⁵ With indentures, it is not so easy.

Indentures typically permit amendments without noteholder consent to cure ambiguities, omissions, mistakes, defects or inconsistencies, or where the amendments do not adversely affect the rights of any holder. It is difficult to argue, however, that changing the benchmark rate of a floating rate indenture, which will directly affect interest payments, is a ministerial change. The replacement of LIBOR with a risk-free rate could result in value transfer from noteholders to issuers. And, because the replacement rate may result in lower interest payments to noteholders, unanimity may be required for amendment. Also, LIBOR may continue to be supported by its administrator, undercutting the justification for replacing LIBOR without noteholder consent under the guise of defect correction.

LIBOR Successor/Fallback Rate in New Indentures

How issuers will deal with existing LIBOR-based floating rate indentures whose securities mature after 2021 is unclear. But drafters of new indentures have the opportunity to address the issue before it ripens into what may be an intractable situation.

At present, it may not be possible to specify with particularity a fallback rate to replace LIBOR. Although the attentions of ISDA and ARRC are focused on the RFR Replacement Rate, no market consensus on a successor to LIBOR has yet emerged. Instead, drafters should  provide issuers with flexibility to designate an industry-standard replacement rate when a consensus on a successor to LIBOR does emerge. One challenge will be adjusting for intrinsic differences between LIBOR and any successor rate, such as the risk adjustment discussed above, so as to preserve the bargained-for economics of the debt.

One recent floating rate indenture6 has taken the approach of tying a successor rate to the benchmark rate in the issuer’s credit facility, on the theory that an amendment to the credit agreement can be accomplished more readily than modification of the indenture. The provision there for a LIBOR replacement reads as follows:

If the rate previously quoted on the Reuter Page LIBOR 01 has been discontinued or is otherwise no longer in effect, LIBOR shall mean a successor rate, including any adjustments thereto, applied in a manner consistent with market practice, selected by the Company in its reasonable good faith judgment to maintain the then-current yield on the Notes to the extent reasonably practicable, and consistent with the definition of LIBOR employed by the Company and the administrative agent under the Credit Agreement, if applicable, which successor rate shall be identified in an Officer’s Certificate delivered to the Calculation Agent not less than 30 days prior to the date that such successor rate shall become effective.

In addition to the tie-in to the credit agreement, the provision:

• gives the issuer leeway to adjust spreads to reflect differences between LIBOR and the replacement; and
• provides for advance notice of the replacement to the calculation agent, thereby affording an opportunity for some independent check on the replacement benchmark and any related adjustments.

An alternative approach could be to modify the amendment provisions of the indenture, as to allow an amendment without noteholder consent to designate a successor to LIBOR, subject to appropriate parameters that assure a transition to the new reference rate that is economically neutral to the extent possible. 

Conclusion

Although many issues remain unresolved at this time, a consensus on one or maybe multiple successor rates to LIBOR will likely emerge in the near future. The successor rate(s) may come from the work currently being conducted by ISDA, the Federal Reserve, or other industry or regulatory initiatives. Issuers are advised to monitor developments in the area, especially if they are contemplating the issuance of floating rate debt with maturities that extend beyond 2021.

There does not appear as yet to be any industry solution that addresses substitution of LIBOR in existing floating rate indentures with debt maturing after 2021. Issuers, underwriters and investors currently negotiating with respect to the issuance of new floating rate debt securities have the opportunity to address the problem at the drafting stage. They should consider providing for the substitution for LIBOR in 2021 with a to-be-identified market-approved reference rate, with a mechanism that will be workable and flexible, and will provide for an economically neutral transition, to the extent possible.

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¹ The “Financial Stability Board, Reforming Major Interest Rate Benchmarks,” July 22, 2014 is available here .
   The “Financial Stability Oversight Council, 2014 Annual Report” is available here.

² “The ARRC Selects a Broad Repo Rate as its Preferred Alternative Reference Rate,” June 22, 2017, is available here.

³ Currently the ICE Benchmark Association.

⁴ “Benchmarks – Fallbacks for LIBOR and other key IBORs,” the webinar slides can be found here.

⁵ ISDA typically facilitates such industrywide amendments by publishing a protocol amending all relevant derivatives transactions between two signatories of the protocol. During the ISDA webcast it was reported that ISDA will most likely adopt the same approach in this instance.

⁶ Indenture of VICI Properties 1 LLC, dated Oct. 6, 2017, with respect to First-Priority Secured Floating Rate Notes due 2022. The notes were issued to former first-lien noteholders of Caesars Entertainment Operating Co. in a bankruptcy reorganization. Kramer Levin served as counsel to certain of the former first-lien noteholders.