Thursday 03 January 2019
Once again, the chapters of this book will provide property investors with straightforward legal guidance from each local country counsel concerning the law and customary practices of various jurisdictions with respect to the acquisition, sale, ownership, development, leasing and financing of property cross-border. There are, however, recurring incidents, developments and conditions that occur within the sector that may adversely affect properties in the market. Property markets can be in equilibrium with strong apparent real estate fundamentals; but then too much capital, persistent historically low interest rates, overbuilding, excessive leverage or gearing, unsustainable property values and ever-declining capitalisation rates have caused booming real estate property markets to crash in the past. Yet all of those are unquestionably internal factors that are endogenous to local property and national capital markets. Hence, the inevitable boom and bust journey seems to be a natural lifecycle of property markets generally.
As we have discussed in prior Global Overviews, disruption can be caused by known or unknown exogenous events or conditions developing over time. 31 December 2021 may be such a date in global financial and, therefore, global real estate markets, as the world’s most important benchmark reference rate is scheduled to end its long run as the global reference rate. Unquestionably, the London Inter-Bank Offered Rate (Libor) is an integral part of nearly every type of financial product available in financial markets worldwide, from relatively simple consumer products to the most complex and sophisticated structured commercial products and derivatives in the capital markets. Libor is the rate that contributor banks in London offer each other for inter-bank deposits (ie, funds loaned to them). Despite being tainted by the recent manipulation scandal – after an investigation in 2012 of an industry-wide scandal involving the manipulation or ‘fixing’ of Libor by a few contributor panel banks, the UK Financial Control Authority (FCA) assumed oversight over Libor in 2013, and in 2014 appointed the Intercontinental Exchange Benchmark Administration (IBA) in London to administer and publish Libor – the financial industry until recently generally believed that Libor should be reformed to continue as the global pricing benchmark in all five of its current iterations: US dollar, UK sterling, euro, Swiss franc and Japanese yen, all of which are quoted in seven different tenors or maturities: one-day, seven-day, one-month, two-month, three-month, six-month and one-year.
End of Libor
However, the growing scarcity of actual inter-bank unsecured term money market funding since 2008 and the growing reluctance of the Libor panel banks, because of potential liability and reputational concerns, to offer ‘expert judgment’ or ‘market-based’ observations without a basis in actual inter-bank transactions, have led the FCA, which now regulates Libor, to publicly acknowledge that ‘the survival of Libor on the current basis . . . could not and would not be guaranteed’ after 31 December 2021 (cessation). National financial regulators of the five Libor currencies have also concluded that Libor must be replaced with an alternative benchmark rate based firmly on actual verifiable trading transaction data from relevant market participants in a ‘sufficiently active’ market of substantial volume, which would therefore be less susceptible to manipulation.
An alternative benchmark
Initiatives have been undertaken in the UK, the EU, the US, Switzerland and Japan to replace their respective currency Inter-Bank Offered Rates (Ibors) with a risk-free (or near risk-free) reference interest rate for UK sterling, euro, US dollar, Swiss franc and Japanese yen transactions, and each initiative has, to date, provided at least one secured or unsecured proposal for its subject currency. Unfortunately, these five separate currency-specific efforts will yield five different independent benchmarks, not a single global benchmark rate as Ibor is now. How this fragmented approach to national benchmarks will affect the global financial markets cannot be predicted. A discussion of the current ongoing US initiative to transition away from Libor to a new benchmark reference rate as its replacement will clearly illustrate the complexity and enormous effort and daunting challenges entailed in the process of transitioning to new alternative reference rates as benchmarks before cessation.
In the US, the Board of Governors of the Federal Reserve System has brought together various US market participants to form the Alternative Reference Rates Committee (ARRC) under the auspices of the Federal Reserve Bank of New York (NY Fed), with the mandate to identify a set of preferred US dollar risk-free rates as sustainable alternatives to Libor. Beginning in November 2014, ARRC was asked by the regulators to:
- identify an acceptable risk-free (or nearly risk-free) alternative reference rate consistent with existing principles for financial benchmarks of the International Organization of Securities Commissions, regarding the ‘rate’s construction, governance and accountability’;
- consider how to assure that benchmark-referenced contracts are properly designed to deal with material alteration or cessation of an existing or new replacement rate;
- develop a plan outlining an adoption process for market participants and their regulators to assure voluntary acceptance and use of the new benchmark; and
- establish an expected timeline for implementation of the new benchmark and create observable measures of success.
Throughout this on-going process, ARRC has been actively engaged in work with the International Swaps and Derivatives Association (ISDA), which is a non-voting participant of ARRC. Recognising that regulators have a responsibility to ensure that the use of reference rates does ‘not pose undue risk to the institutions . . . to market integrity or overall financial stability’, ARRC assembled an advisory group of different Libor end users ‘to ensure that its recommendations reflected a wide consensus of market participants’. Advisory group membership is organised into several specific cash product and derivatives working groups. On 22 June 2017, ARRC announced its identification of the Secured Overnight Financing Rate (SOFR) as the consensus best practice rate, and in October 2017 it adopted a staged plan setting forth the ‘specific steps and timelines designed to encourage use of its recommended rate’ in the cash and derivative markets (the Transition Plan).
Then the NY Fed announced on 3 April 2018 that it had begun ‘publishing [SOFR as] reference rates based on overnight repurchase agreement (repo) transactions collateralised by Treasury securities’.
In November 2017, the NY Fed announced that it would expand the membership of ARRC in 2018 to include a broader set of market participants and additional ex officio members to directly address:
- legacy contract triggers and fallbacks; and
- the transition for cash products as well as derivatives away from Libor.
It also assembled several working groups, including a group of trade associations and a broad range of market participants, to advise on specific issues with respect to corporate loans, consumer loans, floating rate notes and securitisations, as well as legal and accounting issues.
Yet identifying and publishing new alternative reference rates are only the first steps in the global process of replacing Libor as the international benchmark. Implementing the Transition Plan will involve a considerable investment of time and coordinated effort by, as well as great expense for and risk to, market participants in the cash and derivative markets in initiating, conducting and completing (as well as educating market participants about) all of the necessary disparate initiatives outlined, and timelines set, for the myriad cash and derivative products and their related market sectors across the financial markets, including:
- encouraging the adoption of the proposed alternative rate as the replacement benchmark for all, or at least most, transactions currently relying on Libor in US dollar derivatives and other financial contracts;
- constructing the necessary protocols and related infrastructure to allow the programmatic determination of the proposed alternatives in sufficiently active and substantial markets to avoid the risk of manipulation;
- supporting ISDA or a new independent administrative body to develop and implement uniform procedures to determine the appropriate compensating spread to cover the difference between the unsecured Libor rate (with its embedded counterparty credit-risk spread) and the secured risk-free SOFR rate to create the actual replacement benchmark equivalent to Libor;
- convincing parties and counterparties that SOFR plus the compensating credit spread as a replacement benchmark rate is reasonably equivalent to the Libor rate and an acceptable substitute benchmark;
- developing and recommending significantly more detailed as well as uniform trigger arrangements and timing thresholds for the transition from Libor to SOFR acceptable to market participants for use in their floating rate cash products as well as derivatives contracts; and
- fostering a robust market for SOFR swaps and SOFR futures that is sufficiently active and liquid to allow different tenors of SOFR to be observed from actual long-term trades, and allow for creation of tenors similar to Libor.
Market participation and consensus
While ARRC has produced its ambitious Transition Plan, it is the innumerable borrowers, lenders, syndicate parties, investors, bond and note holders, issuers, investors and other market participants in the global financial markets – which hold more than US$200 trillion of loans, bonds and floating rate notes, short-term instruments, securitised products, deposits and other financial contracts, as well as the counterparties to hundreds of trillions of dollars in over-the-counter and exchange-traded derivatives using US dollar Libor, which with UK sterling, euro, Swiss franc and Japanese yen IBOR derivatives and non-derivative financial contracts represent a notional aggregate amount of approximately US$370 trillion – which must accept and successfully transition their floating rate cash products as well as derivatives to the new benchmark rates within the staged timelines of the Transition Plan before cessation. In a concerted effort to coordinate the work of disparate market participants by focusing them on the issues, obstacles and possible solutions, a group of trade associations (the Association of Financial Markets in Europe, the International Capital Markets Association, the Securities Industry and Financial Markets Association, and its asset management group) together with ISDA joined together in response to regulators’ request for the engagement, help and support of end users of Libor. In February 2018, the trade association group issued a white paper that provides a survey of the current state of the financial regulators’ plans; the work of public/private sector groups; and a roadmap of the challenges faced in the transition (the Roadmap).
To avoid (or at least minimise) the impact of cessation on the floating rate cash products and derivative instruments in its portfolio, any party to a Libor-based contract or derivative product (Libor Parties) needs to focus its attention on and anticipate some of the risks embedded in its own portfolios that may arise during the transition, as well as from Libor’s eventual but inevitable cessation. Given the immense size and infiltration of Libor in the global markets since its inception as a benchmark in 1969 and the expected resistance in the market from some participants, unanticipated obstacles and concomitant risks may well be encountered as an unintended consequence of some developments in the transition away from Libor and the attempt to replace it with SOFR in one or more floating rate cash products as well as derivative contracts in multiple interrelated markets. The Transition Plan can only succeed if the planned sequence of steps leading up to the derivatives and cash product markets’ acceptance of the benchmark rate is accomplished in the appropriate sequence as envisioned within the critical timeline.
Unfortunately, if Libor publication is temporarily interrupted or unavailable, there exists no uniform trigger to a fallback alternative rate in the market. These trigger fallback provisions vary as often within lenders’ organisations as they do among different lenders. Extant agreements usually provide for a short-term alternative mechanism for determining the unsecured inter-bank lending rate either directly from the usual Libor quoting banks or specifically designated ‘reference’ banks, but if such determination is not possible in a market disruption, most agreements then default to using the prime or base rate, or the effective fed funds rate (outside of the US, the lender’s cost of funds). It was never contemplated in these Libor agreements or derivatives products that a permanent replacement to published Libor would be necessary; and being standard boilerplate, the fallback provision for such a highly unlikely event was rarely the subject of any negotiation. Thus, every agreement will need to be identified, its terms renegotiated and amended to substitute the new replacement rate with the consent of all of the parties to the contract, whether bilateral or multilateral.
Thus, notwithstanding that cessation is more than three years in the future, the best way to mitigate the risk of failure for Libor Parties is to undertake an in-depth examination of their portfolio of Libor-referenced assets to identify floating rate cash products as well as derivatives and catalogue them to create a database of the specifics of their maturity (including extensions), any additional obligations in the governing documents that may be tied to Libor (eg, rate cap or swap), their contractual Libor fallback arrangements and, if fallback is inadequate or nonexistent, the rate change consent requirements, if any, in the applicable governing transaction documents. It is critical and prudent that each market participant focuses on the establishment and training of a separate Libor team with the requisite expertise to conduct the necessary due diligence, manage and organise the data collection, isolate bespoke fallback provisions, perform a detailed cost analysis, determine the possible value transfer, monitor the new replacement rates in the origination, securitisation and derivatives markets, and analyse the overall impact of cessation on the Libor portfolio, as well as the transition to SOFR, and report directly to senior management to assure organisational consistency of approach internally and externally.
Caution should also be exercised in the origination of new cash product contracts that would be adding to the pre-cessation legacy portfolio of Libor Parties. Libor Parties should endeavour to adopt uniform fallback triggers aligned as closely as possible to any fallback triggers being developed in ARRC’s working groups and ISDA or, if none is available, which at least conform to the more robust fallback triggers being developed by other Libor Parties currently active in the market taking transition as well as cessation into account in their drafting. But at all costs, Libor Parties should ignore all advice, or counterparty requests, to create new, or to continue to use, bespoke provisions that will result in their portfolios becoming more problematic in the coming transition, with increasing exceptions to uniform new benchmark conversion within their own book. The best mitigation strategy is to continue to monitor the progress and publications of ARRC in the implementation of its Transition Plan.
At present, ISDA is working with the ARRC working groups to develop fallback triggers for derivatives contracts at the ‘definitive and publicly known’ permanent discontinuance of Libor; but there are many market participants who have expressed serious concern that fallback triggers should also be developed simultaneously for Libor-based cash products in addition to the four derivative contract-focused trigger scenarios that have been developed and are currently being proposed by ISDA. Having common uniform fallback triggers for both cash and derivatives products would synchronise the transition from Libor and allow different product markets to convert simultaneously. If the entire market were able to convert to the new benchmark on a consistent basis, then it would avoid the real risk of a mismatch in the rates between cash products and derivatives, eg, loans and related derivatives contracts triggering at different times, or the derivatives converting but the related loans not converting, or some asymmetric combination when only part of each market converts. ARRC has acknowledged that such divergence can cause significant dislocation in the markets and that cash product groups should now coordinate with the derivatives products groups in the development of the appropriate fallback triggers for cash products to add to ISDA’s proposed fallback triggers.
Some market participants have commented that that they would like fallback triggers that convert away from Libor to the new benchmark when it is recognised by the market as an industry standard. But that begs the question of acceptance in which market by which industry. The issue was succinctly described by BlackRock as a ‘chicken or egg problem’, stating that ‘investors will not adopt [alternative reference rates (ARRs)] if liquidity is insufficient, but sufficient liquidity will not develop if investors do not adopt ARRs’.
Without question, liquidity will be the single most important step in the transition from Libor. The successful and sustained growth of swaps and futures for SOFR in an active derivatives market will be necessary to assure that there will be sufficient robust trading activity to support the cash products referencing the new replacement benchmark rate. And that growing liquid trading will eventually permit a SOFR term curve to be derived from the observation of longer-term trades. Yet there is still the issue of the compensating credit embedded in unsecured Libor that is missing in secured SOFR. How that compensating credit spread will be derived, calculated and adjusted, or whether it will be static, dynamic or absent, or who will be responsible for creating and monitoring that spread, will be the subject of a public consultation on credit spread methodology which is being released by ISDA. However, to the extent that any avoidable value transfer can be mitigated or prevented in the transition from Libor, the compensating credit spread must be an integral part of the eventual replacement benchmark if it is to be a reasonable equivalent to Libor in cash or derivatives contracts. SOFR plus the compensating spread can be characterised for those purposes as the SOFR Index. That would alleviate any operational problems for the systems of some major market participants that can only generate two factor interest rates.
A relatively significant, but oddly rarely discussed, consequence of the transition from Libor to SOFR or any replacement benchmark is the possibility that changing (modifying) the interest rate on debt instruments, including variable rate debt instruments, may trigger a ‘sale or exchange’ transaction with the attendant tax consequences under the US Internal Revenue Code. In effect, the ‘old’ note is deemed to be exchanged for the ‘new’ note, and there may (or may not) be gain or loss recognised on the transaction, but it depends on the specific facts and circumstances of each note and on the related ‘applicable federal rate’ in effect at the time of the modification transaction. However, if a modification of obligations occurs automatically by operation of the express terms of, or the exercise of an option contained in, the debt instrument, it would generally not be deemed a taxable modification for Internal Revenue Service (IRS) purposes. While that exemption should work generally for new debt instruments expressly hardwired by incorporating new fallback language, the modification risk would exist when a legacy debt instrument is amended to add the fallback trigger to SOFR or the replacement benchmark. Whether the fallback must be specific to SOFR or may be simply to a new substitute benchmark generally accepted in the financial markets as a replacement for Libor is unclear and needs to be clarified by the IRS. It would be prudent for market participants to seek a marketwide exemption from the IRS with respect to the potential US tax consequences in the case of the transition to SOFR or any other designated replacement benchmark before Libor Parties engage in a wholesale conversion (or modification) of their existing non-hardwired debt instruments to the alternative benchmark in existing Libor-based debt instruments. Although the rate differential may not trigger the sale or exchange tax consequences, given the potential for Libor to continue after cessation with a possible different calculation, prudence would dictate having the IRS confirm that adopting the best practice replacement rate recommended by the financial regulators should not be a taxable event as it did in the conversion of national currencies to the euro.
Capital markets implications
Beyond each market participant’s own analysis of the risks that may result from the discontinuance of Libor to its portfolio and the transition to the replacement reference rates – including the effect of inconsistent, inadequate or missing fallback provisions; the potential risks in any attempt to amend cash and derivative contracts; possible impact upon liquidity; long-term asset valuation shift; a potential disconnect between cash and derivative product markets; market disruption, etc – such analysis may, depending on the circumstances, also need to be disclosed to any investors under the securities laws to the extent applicable within its portfolio, including in its securitisation of affected assets.
As the most recent financial crisis demonstrated, financial markets are interconnected and dependent in unexpected and sometimes unintended ways. The sophisticated institutional counterparties in the derivatives markets, who are usually governed by market protocols promulgated by ISDA, are very different players from the commercial loan borrowers and light years away from average consumers who will be affected by the transition from Libor. The risk of legal disputes and reputational damage is inevitable in any transition possibly affecting a value transfer within a US$370 trillion market.
Syndication agents, lead lenders, co-lenders, participants or other parties in intercreditor arrangements may be unable to agree on the transition among themselves or incapable of doing so for purely operational reasons. Moreover, instructions given by lenders or trustees to third-party loan servicers who either refuse to be the party responsible for communicating the implementation of the transition instructions or demand indemnities against liabilities for implementing such instructions may further complicate the transition. Thus, the transition will unavoidably be operationally complicated and potentially extremely contentious.
As with any industry-wide interaction and consensus-building process, there is the risk of a perceived violation of the antitrust laws as well as potential conspiracy claims both in the US and in other countries, especially as financial institutions gather to discuss market pricing issues such as interest rates and spreads. External discussions held by or among teams as well as individuals should only be conducted with the consent and clearance of antitrust and bank compliance counsel, which should also work directly with the internal Libor team to assure proper compliance with Dodd-Frank and other federal regulatory regimes.
In March 2018, the NY Fed promulgated new Antitrust Guidelines for Members of the Federal Reserve Bank of New York’s Advisory and Sponsored Groups to be proactively observed by the members of ARRC and its working groups in their continuing discussions of Libor cessation and the transition to a replacement benchmark rate. Industry groups and market participants should also adopt and strictly observe in the conduct of their formal and informal discussions, meetings, conference calls and correspondence, electronic or otherwise, both internally and externally, and should ensure strict compliance by all personnel.
In accordance with the paced transition process and timeline schedule under its Transition Plan, ARRC has begun to release, in stages, the final Work Product of each of its cash product Working Groups to gather additional feedback from other market participants with respect to the more robust language proposed for new Libor contracts to ensure that these contracts will be effective when Libor is no longer usable.
In July 2018, ISDA separately released for public review and comment its proposed fallback rate and credit spread adjustments. The ultimate goal is to guide the derivatives market on its adjustment of the new SOFR overnight rate for both term and credit risk. It was also intended that the ARRC Working Groups would take into consideration the ISDA proposals in their transition triggers, fallback rates and spread waterfalls, as well as incorporate the ISDA definitions for use in their cash products consultations. Several industry trade associations, as well as other individual market players, have commented on the ISDA consultation. ISDA intends to publish a protocol for the derivatives market to facilitate the inclusion of ISDA definitions and fallback language in legacy Libor derivatives contracts. ISDA has also proposed specific cessation triggers away from Libor to the replacement benchmark.
In September 2018, ARRC began the release of its Working Groups’ consultations, beginning with the Libor Floating Rate Notes Consultation and the Libor Syndicated Business Loans Consultation. Consultations on other cash products, including securitisations, bilateral loans and consumer products, will also be issued in due course. In its Guiding Principles for Fallback Language, ARRC stressed the benefit of consistent language across all cash products. In general, the consultations all are consistent with the two ISDA cessation triggers, but have each added several additional pre-cessation triggers for different cash products. In addition, each Working Group’s consultation has proposed one or two additional triggers perceived to be unique to their cash product. The consultations also contain rate fallback waterfalls.
After considering all the public feedback to the separate consultations, ARRC will decide which comments to include, as well as which proposed provisions to delete, and then issue final contract language recommendations for consistent triggers, fallbacks and defined terms for voluntary use by market participants in their particular cash products.
There has been continuing discussion of the possibility of keeping Libor alive after its cessation (as a regulated rate) for a variety of perceived benefits to the market and its participants. While the FCA will no longer compel panel banks to sustain Libor after cessation, Libor may not simply cease to exist because some market participants – including the Libor administrator, the IBA (which recently announced a gradual transition to a new voluntary bid system from contributor banks on actual transactions rather than expert opinions) – would prefer its continuance, although it is unclear how such Libor would be determined in a continually contracting market. Claiming that there is an overwhelming preference in the market to continue Libor, the IBA has been urging investors, borrowers and lenders to pressure the panel banks to continue contributing voluntary bids. The continuance of Libor publication after cessation will be a double-edged sword, with some benefits as well as substantial risks. Continued existence would provide aggrieved borrowers and possibly debt market investors with a baseline from which to measure their claim for perceived damages or value loss from the transition to SOFR, or any other replacement reference rate, plus a compensating credit spread, as being neither a commercially reasonable equivalent to Libor nor the result of good faith and fair dealing. Such continuance, however, raises the spectre of an even more draconian claim that because Libor is still published, it should continue to be the fixed rate for the balance of the contract’s term.
Despite Libor no longer being officially supported at cessation, consumer or commercial Libor Parties could argue that the last Libor rate published before cessation should be the static fixed rate for the balance of the term of their cash product, in effect becoming a ‘zombie’ rate. In fact, some contracts in the market have recently adopted the final published Libor as being ‘Static Libor’, the fixed rate for the balance of the term after cessation. Stranger claims have been made successfully, especially against financial institutions perceived as ‘manipulating’ consumers’ interest rates on their debts.
Although SOFR has been identified by ARRC as the proposed reference rate to replace Libor, there is no legal or other governmental or quasi-governmental requirement for market participants to adapt SOFR on cash products or derivatives, only the pressure of a growing liquid SOFR market and a shrinking less liquid (and possibly more volatile) Libor market, and there remain several significant recognised obstacles to the transition that must be successfully overcome before SOFR will be accepted as the replacement benchmark for Libor across the vast array of affected product types.
ARRC, together with its working groups and market participants, must address (among a myriad of other issues):
- the creation of a forward-looking credit risk-embedded benchmark based upon SOFR, (as the backward-looking secured replacement rate does not have an existing counterparty credit-risk premium or a cost-of-funds component);
- the development of uniform fallback rate triggers and flexible timing for the transition from Libor to SOFR;
- the weaker fallback provisions in legacy contracts for periods when Libor is unavailable and the better fallback provisions for cessation that should be built into new contracts;
- the anticipated economic consequences of the value shift during the transition;
- implementation of operational infrastructure for the calculation, determination, transition and maintenance of SOFR;
- tax and accounting issues occasioned by the transition to a new rate;
- adoption of institutional governance and controls for risk management during the transition;
- the limitations of existing regulatory regimes; and
- the liquidity of derivatives markets for SOFR-referenced products in order to develop the necessary term structures for the new benchmark.
In addition, Libor Parties must be prepared for:
- the increasing volatility of Libor as its trading volume further recedes as SOFR’s liquidity improves;
- the possible volatility of SOFR, which, unlike Libor, will not be tempered by panel banks’ appraisal bias; and
- the inevitable contentious discussions among Libor Parties over value transfers in the transition.
The inability of participants in global financial markets to deal effectively with the foregoing challenges, their possible failure to resolve the deficiencies of or to develop sustainable liquidity for any replacement benchmark in the derivatives markets and thus the failure to arrive at the ultimate goal of substituting new alternative reference rates as sustainable benchmark rates acceptable to the origination, securitisation and derivatives markets, could be virulently disruptive throughout the world financial system given the immense presence of Libor in every aspect of financial products.
At a Bank of England Market Forum held on 24 May 2018 in London, the NY Fed President warned of:
. . . the great uncertainty over Libor’s future and the risks to financial stability that would likely accompany a disorderly transition to alternative reference rates . . . [W]e need aggressive action to move to a more durable and resilient benchmark regime.
Whether his acknowledgement of the financial regulators’ important role in working with market participants in the transition might signal a possible official involvement to assure an orderly transition is unclear.
Notwithstanding that we know about Libor’s scheduled cessation and have identified in great detail the steps that must be successfully accomplished, as well as in what sequence to accomplish a transition without significant market disruption, it is nearly impossible to know or anticipate any and all of the unintended consequences of any deviation, complication, delay in or outright resistance to the implementation and acceptance of any transition plan.
The transition could ‘have truly catastrophic and unpredictable effects’ on the global financial markets, as well as on Libor Parties. Given the potential systemic risks involved, market participants – regardless of their size or the size of their portfolios or the magnitude of their Libor exposure – should educate themselves on the transition, understand the details of their Libor cash and derivatives portfolio, as well as their economic, operational and legal risks, before cessation to assure themselves as much as possible of an orderly transition of their portfolios to the new replacement benchmark.