The End of LIBOR: Hotel California Edition [Part III]

As much of life, timing is everything.

­­Lack of Economic Equivalence Requirement

Although the Internal Revenue Service (IRS) initially proposed a requirement of a substantially economic equivalent transition of interest rates in connection with the LIBOR transition on October 8, 2019 to avoid a tax event for either party, this was modified in final regulations issued on December 30, 2021.

Instead, the final IRS requirement was to follow the provisions of the Adjustable Interest Rate (LIBOR) Act enacted in March 2022, and related Federal Reserve rules, collectively known as the LIBOR Transition Rules. If these were followed, a tax event was avoided, even if the LIBOR transition was significantly economically disadvantageous to a particular party.

Specifically, the LIBOR Transition Rules required the use of the applicable approved benchmarks plus the applicable benchmark spread adjustments tied to the tenor of the interest rate period of One-Month Term SOFR, 30-Day Average SOFR or Daily Simple SOFR. As previously reported in The End of LIBOR: The Twilight Zone^TM Edition, the benchmark spread adjustments, which became effective on March 5, 2021, were determined by the International Swap and Dealers Association (ISDA), a bank trade association. As determined by ISDA and published by Bloomberg as the vendor for the fallbacks in the ISDA documentation, the benchmark spread adjustment was 11.448 basis points for One-Month LIBOR (relevant for the general analysis in this alert) and 26.161 basis points for Three-Month LIBOR (relevant for the Standard Chartered case discussed below).

To the extent that a party was interested in maintaining the same economics for a financial instrument during the transition, it was primarily dependent upon when the transition occurred – specifically, when the new or amended financial instrument was entered into by the parties.

Periods of Benchmark Rate Compression/Divergence

Compression

From December 2019 through December 2021, benchmark rates were generally substantially equivalent between One-Month LIBOR and One-Month Term SOFR. However, if the ISDA benchmark spread adjustment was used – though not officially approved or deemed effective by the United Kingdom Financial Conduct Authority (UK FCA) and the Alternative Reference Rates Committee (ARRC) until March 2021 – the ultimate interest rates diverged and so were generally more favorable to lenders than borrowers during this period. Importantly, as noted below, our experience was that most transitions to alternative benchmarks occurred subsequent to this period.

In addition, benchmark rates were comparable between One-Month LIBOR/One-Month Term SOFR and 30-Day Average SOFR for June 2023 (immediately prior to the LIBOR end date). Subsequent to the transition, interest rates were comparable between One-Month Term SOFR and 30-Day Average SOFR, excluding the now inapplicable ISDA benchmark spread adjustment (see No Benchmark Spread Adjustments Post LIBOR End Date below), making them fair to all parties.

Divergence

Generally, except as noted above, benchmark interest rates between One-Month LIBOR/One-Month Term SOFR and 30-Day Average SOFR, including the ISDA benchmark spread adjustment when legally established upon enactment of the LIBOR Transition Rules through the LIBOR end date, diverged in the following periods:

• March 2022 through December 2022.
• July 2023 through mid-August 2023.

Detailed Compression/Divergence Summary

The following table utilizes a general average of the differential between One-Month Term SOFR and 30-Day Average SOFR, including any applicable ISDA benchmark spread adjustment. The table is based upon snapshots, often taken on the first business day of the month within each quarter, until tracking began on a weekly basis in 2023 (though it was never tracked on a daily basis):

It should be noted that wide differentials were generally in favor of lenders, except as otherwise indicated. In our experience, (1) Term SOFR only started to be earnestly utilized in lieu of the switch from LIBOR → LIBOR beginning in January 2022, and (2) Daily Simple SOFR was rarely utilized for non-swap financial instruments, so it is not reflected in this table.

No Benchmark Spread Adjustments Post LIBOR End Date

During the transition from LIBOR to a benchmark replacement, a benchmark spread adjustment determined by ISDA was added pursuant to the LIBOR Transition Rules (whether or not it was warranted). However, since there is no longer a LIBOR transition, this benchmark spread adjustment is no longer applicable.

Yet, the Standard Chartered PLC case described below inexplicitly utilizes the now inapplicable ISDA benchmark spread adjustment in determining economically equivalent interest rates after the end of “Zombie” LIBOR.

In addition, a fixed ISDA benchmark spread adjustment was adopted by ARRC with the presumption that economic conditions would remain relatively calm. However, subsequent to March 2021, there was the continuation of the pandemic and related supply shocks, and Russia’s invasion of Ukraine, leading to significant inflation and increases in interest rates, as well as recent tumultuous market conditions.

Consequently, it is unclear whether economic conditions have been relatively calm to warrant a fixed ISDA benchmark spread adjustment through the LIBOR end date, or for the foreseeable future, especially since the spread adjustment is no longer applicable.

Recent Relevant UK Case[1]

Case Background

In 2006, Standard Chartered issued a series of USD $750 million preference shares, with dividends paid at a fixed rate of 6.409% until January 20, 2017, and subsequently at a variable rate of 1.51% plus Three-Month USD LIBOR. The preference shares were issued to investors in the form of American Depository Shares (ADS).

As LIBOR was no longer published after June 30, 2023, a transitional synthetic LIBOR rate, known as “Zombie” LIBOR”, was permitted to be used by the UK FCA. The use of this rate was restricted only to certain difficult-to-transition financial instruments, such as securitizations, and ended on September 30, 2024.

On April 12, 2024, Standard Chartered sought declaration from the UK High Court of Justice, under the Financial Markets Test Case Scheme, for the rate at which dividends should be calculated on the preference shares for the periods subsequent to the end of “Zombie” LIBOR. Standard Chartered argued for an alternative benchmark rate using Three-Month Term SOFR plus the ISDA benchmark spread adjustment of 26 basis points. This is the same formula used to calculate the soon to be terminated “Zombie” LIBOR rate.

On the other hand, certain holders of ADS argued against Standard Charter’s proposed rate and sought declaration that “a term should be implied into the terms of the [p]reference [s]hares that if three-month USD LIBOR ceases to be available the Claimant shall redeem the [p]reference [s]hares.”

Court Ruling

The UK High Court agreed with Standard Chartered that there is an implied term that if the express definition of the Three-Month LIBOR ceases to be capable of operation, dividends should be calculated using the reasonable alternative rate to Three-Month LIBOR at the date the dividend fails to be calculated. The High Court determined that LIBOR’s role in the preference shares was non-essential “machinery.” When LIBOR can no longer be calculated, the courts will not permit termination of the contract through impossibility of performance, especially due to an unforeseeable event. Instead, they will simply permit the substitution of an alternative interest rate calculation, as long as reasonable – presumably ensuring that there is no change in the economics of the financial instrument.

The High Court also concluded that, first, the identification of the reasonable rate is an objective question, with the ultimate arbiter being the court rather than Standard Chartered. Second, the universe of available reference rates may change over the life of the preference shares, including if another substantial interbank unsecured lending market were to re-establish itself.

Analysis

While it is unclear whether “Zombie” LIBOR was permitted to be used by the UK FCA to calculate dividend payments by Standard Chartered, it is clear that the use of the ISDA benchmark spread adjustment ended no later than the termination of “Zombie” LIBOR on September 30, 2024 – two weeks before the High Court rendered its decision. Use of this ISDA benchmark spread adjustment thereby increased the cost of the dividends paid by Standard Chartered, exceeding actual interest rates either subsequent to June 30, 2023, or through the resurrection of “Zombie” LIBOR by Standard Chartered on October 30, 2024.

Reasonable Equivalence

Determining whether the new effective interest rate was similar to what parties were paying before the LIBOR transition, as well as the interest rate expected by the parties for new facilities going forward, was dependent upon the length of time that a financial instrument was outstanding during the periods of interest rate compression, when rates were generally fair to all parties, as compared to the length of time during periods of interest rate divergence.

In connection with a variable rate facility without a swap, the initial interest rate would adjust over time to a fair rate, even if a significant portion of the facility was outstanding during periods of interest rate divergence. However, if an interest rate swap was entered into in connection with a variable rate facility during a period of interest rate divergence, the new effective rate for the borrower would be tied to the swap, and not change over time, including during the periods of interest rate compression.

The UK High Court ultimately determined, in line with the preliminary decision by the IRS, that the transition from LIBOR should be (and likely should have been) a reasonable rate compared to now-deceased LIBOR and “Zombie” LIBOR. Nonetheless, despite the sound reasoning behind its ruling in utilizing a cy-prés concept, the High Court decided to resurrect “Zombie” LIBOR, adding 26 basis points in determining future rates.

In addition, even without the inclusion of the new inapplicable spread adjustment, there was a significant difference between Three-Month Term SOFR (a derivative rate), which was 4.30%, and 90-Day Average SOFR (an actual rate) which was 5.23% – a differential of 93 basis points on the date of the High Court’s decision. This means that the differential per year between a benchmark whose use should be limited per regulator pronouncements (Term SOFR) and an actual rate could approximately be $7 million, depending upon the benchmark utilized as the LIBOR alternative and, since a perpetual timeframe is a long time, this could exceed hundreds of millions of dollars.

Last thing I remember, I was
Running for the door
I had to find the passage back
To the place I was before

– Eagles, “Hotel California”