Committee Seeks Guidance on IBOR Fallback-Related Protocols

December 9, 2019

Mr. David J. Kautter
U.S. Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Ms. Helen M. Hubbard
U.S. Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Mr. Lafayette G. “Chip” Harter
U.S. Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Mr. Mark E. Erwin
U.S. Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Mr. Brett York
U.S. Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Mr. William E. Blanchard
U.S. Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Mr. Michael J. Desmond
U.S. Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Ms. Diana A. Imholtz
U.S. Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Mr. William M. Paul
U.S. Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Mr. Spence W. Hanemann
U.S. Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Ms. Caitlin I. Holzem
U.S. Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Re: Guidance Relating to the ISDA Protocol Regarding the Incorporation of Robust Fallback Provisions to IBOR Reference Rates

Ladies and Gentlemen:

The Alternative Reference Rates Committee (the “ARRC”), a committee convened by the Board of Governors of the Federal Reserve and by the Federal Reserve Bank of New York with the support of a number of agencies including the U.S. Department of the Treasury (“Treasury”), is writing to request standalone guidance relating to one or more Interbank Offered Rate (“IBOR”) fallback-related protocols to be published by the International Swaps and Derivatives Association (“ISDA”) early next year (the “Protocol”).

The ARRC greatly appreciates the Guidance on the Transition from Interbank Offered Rates (“IBORs”) to Other Reference Rates, published in the Federal Register on October 9, 2019 (the “Proposed Regulations”), and the work done by Treasury and the Internal Revenue Service (the “IRS”) to address tax issues arising from the IBOR transition, including issues raised by the ARRC in its prior comments dated April 8, 2019¹ and June 6, 2019.² However, as discussed in further detail below, it is not clear whether adherence to the Protocol or adoption of comparable fallback provisions by parties to a contract will qualify for the relief provided in the Proposed Regulations. Due to the time-sensitive nature of this issue, the ARRC is providing its initial comments with respect to the Protocol in this letter and will separately provide additional comments regarding the Proposed Regulations.

Currently, derivative contracts that are based on ISDA documentation contain fallback provisions that are widely considered by both private-sector participants and the official sector to be highly likely to lead to widespread disruptions in the event of a permanent discontinuation of the relevant IBORs. The Protocol is intended to address this issue by providing a mechanism for parties to remediate their existing contracts, which are massive in number,³ without the need for individual negotiations. Broad market adherence to the Protocol will help to ensure that market participants are protected from the disruption that could occur under the current fallbacks included in ISDA documentation. On the other hand, uncertainty about the tax consequences of adhering to the Protocol could cause market participants to delay adhering to the Protocol or making contractual modifications to implement comparable fallback provisions. Accordingly, the ARRC requests in this letter that Treasury and the IRS issue interim guidance specifically addressing the Protocol.

This letter provides background regarding the mechanics of over-the-counter (“OTC”) derivative contracts based on the standardized documentation published by ISDA, the Protocol and the need for additional guidance. In addition, it provides a description of the guidance that the ARRC recommends to address the concerns raised by the Protocol, including proposed language for such guidance.

I. Background Regarding the Protocol

a. General Background on ISDA Master Agreements and Protocols

ISDA publishes documents, including “Master Agreements” and “Definitions,” which are used to provide standardized terms that form the basic framework of most OTC derivative contracts. Individual trades under an ISDA Master Agreement are generally documented by way of a “confirmation,” which details the terms of the specific transaction and incorporates relevant ISDA Definitions, including the 2006 ISDA Definitions (the “Definitions”) for interest rate derivative contracts. This general framework enables market participants to streamline their negotiations by relying on industry-standard terms, and ensures greater consistency across the derivatives market. This consistency, in turn, reduces risk for market participants.

A protocol is a mechanism to effect a multilateral amendment to existing ISDA-based contracts. Protocols provide an efficient way of implementing standard contractual changes among a large group of parties; in doing so, they enable parties to avoid time-consuming and costly bilateral negotiations. A market participant who wishes to “adhere” to a protocol submits an “adherence letter” to ISDA, which publishes the names of the adhering parties on its website.⁴ If two parties to an ISDA-based contract adhere to a protocol, all of the contracts that they have outstanding with each other will be legally modified in accordance with the terms provided by the relevant protocol as of the date that the last of the parties adhered to the protocol (or as of a later date set out in the protocol). The adherence typically applies to all outstanding ISDA Master Agreements, and associated confirmations, to which the relevant market participant is a party, provided that the other party has also adhered.

b. The Protocol — Process

The current version of “Rate Options” for IBORs in the Definitions does not incorporate robust “fallback” provisions that would provide clarity, certainty and consistency regarding the appropriate replacement rate once an IBOR has been permanently discontinued. At the request of the Financial Stability Board's (the “FSB's”) Official Sector Steering Group,⁵ ISDA has been leading an industry effort to implement robust fallback language for derivatives contracts since 2016.⁶

ISDA has announced that it will amend the Definitions to provide for fallback reference rates in the Rate Options for LIBOR and certain other IBORs to address the circumstances under which those IBORs cease to exist, or possibly cease to be representative, at some point in the future (such provisions, the “ISDA fallback provisions,” and such amended Definitions, the “Amended Definitions”).⁷ The ISDA fallback provisions will contain terms to establish the base replacement risk-free rate (“RFR”) for each IBOR (any such base replacement rate, a “new fallback rate”) as well as a spread adjustment that will apply (the “spread adjustment”).

Simultaneously with the publication of the Amended Definitions, ISDA will publish the Protocol to facilitate multilateral amendments to incorporate the Amended Definitions into outstanding OTC derivative contracts (so-called “legacy derivative contracts”). By adhering to the Protocol, market participants will agree that any legacy derivative contracts with a counterparty who also adheres will be modified to reference the Amended Definitions, including the ISDA fallback provisions. As an alternative to adhering to the Protocol, a party can seek to enter into a bilateral agreement with a derivative counterparty to amend its legacy derivative contracts with that counterparty to include the Amended Definitions, as discussed below.

To determine the methodologies to be included in the ISDA fallback provisions, and at the request of international regulators, ISDA has conducted global, market-wide consultations on various technical issues.⁸ In an October 2019 letter to the Antitrust Division of the U.S. Department of Justice, ISDA affirmed that it made substantial efforts to ensure that the consultations were fair, transparent and objective.⁹ For example, questions were designed to elicit narrative feedback and to avoid limiting or steering responses. To provide procedural safeguards, ISDA engaged antitrust counsel and third-party consultants to assess responses and ensure that information was shared appropriately. The consultations garnered a large number of responses from market participants representing several business sectors and countries. The consultants engaged by ISDA have released reports discussing the responses received and their conclusions based on those responses.¹⁰

ISDA expects to publish the Amended Definitions and Protocol by February 2020 for all IBORs. This publication will mark the beginning of a three-month period during which market participants will have the opportunity to adhere to the Protocol prior to a specific date on which the amendments to the Definitions will take effect (the “Initial Adherence Period”). After the end of the Initial Adherence Period, all new Definitions-based derivative transactions will reference the Amended Definitions, as will all legacy derivative contracts modified pursuant to the Protocol or through bilateral amendments incorporating the Amended Definitions. The occurrence of these changes on the same date should increase market consistency and predictability. LCH and CME have also announced that they will implement rule changes implementing revised fallback language in all derivative contracts they clear, including outstanding derivative contracts, on the date the Amended Definitions take effect.¹¹

Broad adherence to the Protocol during the Initial Adherence Period is of critical importance to the wider goal of ensuring that market participants are protected from widespread disruptions in the event of a permanent discontinuation of the relevant IBORs. John C. Williams, president and Chief Executive Officer of the Federal Reserve Bank of New York, recently stated:¹²

Derivatives contracts account for 95 percent of the exposure to U.S. dollar LIBOR, so universal changes to these contracts would be a significant leap forward. If the market signs up to the Protocol when it's published, it will be a considerable milestone and will go a long way toward reducing risks to firms, markets, and the financial system. . . .

In a similar vein, Randal K. Quarles, vice chair for supervision of the Federal Reserve Board of Governors, recently stated that “it will be crucial in ensuring global financial stability that everyone participate in the International Swaps and Derivatives Association's (ISDA) consultations on better fallback language for LIBOR derivatives and then sign the Protocol so that these fallback provisions apply to the legacy book of derivatives.”¹³

Broad participation during the Initial Adherence Period would signal strong market support for the Protocol and thereby encourage other market participants to adhere to the Protocol as well. Wide uptake of the Protocol will reduce market risk in that parties will be less exposed to varying and unpredictable outcomes that could arise if some of a party's legacy derivative contracts contain the new and more robust ISDA fallback provisions while others do not. This was acknowledged in a letter to ISDA dated March 12, 2019, by the Co-Chairs of the FSB, where they stated that:

The measures that ISDA is taking will play a very important role in the transition from LIBOR and will serve to strengthen contract language in derivatives referencing other IBORs. The adoption of appropriately revised fallbacks by market participants will help to mitigate a key source of risk to the financial system.

On November 7, 2019, the Federal Reserve Board, the FDIC, the OCC, and other agencies released a proposal on adjusting margin requirements for covered swap entities that, among other things, is meant to remove unintended hurdles to adhering to the Protocol and moving away from LIBOR.¹⁴ Additionally, the Financial Accounting Standards Board (the “FASB”) has issued an exposure draft with proposals that would ease the transition from legacy IBORs to RFRs from an accounting perspective¹⁵ and recently affirmed its proposals, with the goal of finalizing the guidance in early 2020.¹⁶

While not all terms of the ISDA fallback provisions are finalized, most material terms have been determined, based on the final consultation results published by ISDA on November 15, 2019.¹⁷ The specific terms of the anticipated ISDA fallback provisions are discussed below.

c. Methodology in the ISDA Fallback Provisions

In the Amended Definitions, ISDA intends to amend the Rate Options to provide that an announcement or publication regarding the permanent discontinuation of an IBOR triggers the ISDA fallback provisions (a “trigger event”).¹⁸ ISDA has not yet determined if the amendment will also provide for a trigger event resulting from an announcement by a regulator that an IBOR is no longer representative (a “pre-cessation trigger”).

Due to the differences between RFRs and IBORs, it will be necessary to adjust the spread above the applicable IBOR in a derivative contract with a higher spread above the applicable RFR. Accordingly, upon a trigger event a spread adjustment will be calculated to take effect when the discontinued IBOR is replaced with the new fallback rate, which in the case of U.S. dollar LIBOR will be the Secured Overnight Financing Rate (“SOFR”). The new fallback rate, together with the spread adjustment, will replace the IBOR as the reference rate under the terms of the contract once the IBOR is actually discontinued (such date, the “replacement date”). ISDA has announced that Bloomberg Index Services Limited (“Bloomberg”) will produce and publish the new fallback rates and the spread adjustments, as well as an “all-in” rate including both, for each IBOR tenor upon the occurrence of the relevant trigger event.¹⁹ Bloomberg will also publish indicative spread adjustments and resulting fallback rates prior to a trigger event.

To determine the spread adjustment accompanying the transition to the new fallback rate, ISDA anticipates the use of a five-year historical median approach whereby the median spread between the relevant IBOR and the relevant new fallback rate compounded over a period that corresponds to the applicable IBOR tenor (e.g., three months) are calculated over a five-year look-back period. In order to avoid distortions due to market disruption during the period between the trigger event and the replacement date, the relevant spread adjustment will be calculated based on the five-year look-back period ending on the business day prior to the trigger event. Attached as Appendix B is an illustration of a hypothetical timeline for the replacement of a relevant IBOR with a new fallback rate in an ISDA-based contract pursuant to the Amended Definitions (which could be incorporated into legacy derivative contracts through adherence to the Protocol or bilateral amendment) and subsequent operation of the ISDA fallback provisions.

There are several adjustments necessary to account for the fact that RFRs are overnight rates and IBORs are forward looking term rates. Under the ISDA fallback provisions, the rate for a payment period will be based on a “backward-looking” compounded setting in arrears rate whereby the relevant new fallback rate is observed over a period of time that is generally equivalent to the relevant IBOR tenor and compounded daily during that period. To deal with the operational difficulty of making a payment on a derivative contract based on a rate that is only known at the end of the period as opposed to the forward looking IBOR rates historically used, it is anticipated that the observation period for determining payments under a derivative contract referencing the new fallback rate will be shifted back by two days. This would mean that the last observation of the new fallback rate for any calculation period would generally be two banking days before the relevant payment date.²⁰

As noted above, a few minor details of the ISDA fallback provisions remain unresolved. Most unresolved terms relate to minor calculation mechanics — for example, incorporating holiday calendars for compounding. ISDA also continues to consider the inclusion of pre-cessation trigger events in the Protocol.²¹ Additionally, ISDA has yet to consult on the methodologies for adjustments to the Definitions in respect of EURIBOR and EUR LIBOR, but expects to do so by mid-December.²² It is possible that the Amended Definitions used by the Protocol will include ISDA fallback provisions for such rates.

d. Bilateral Amendments 

It is expected that some market participants will incorporate the ISDA fallback provisions for IBORs through bilateral agreements rather than adherence to the Protocol. Parties may choose to enter into bilateral agreements for a variety of reasons, including to amend contracts with a non-adhering counterparty, to amend contracts that are not based on an ISDA Master Agreement, based on general practice to effect amendments that could be made by protocols through bilateral agreements, due to governance difficulties in approving a protocol adherence or because of timing issues related to adherence.²³

In many cases involving bilateral amendments, the expectation is that the parties will adopt fallback provisions identical to the ISDA fallback provisions included in the Amended Definitions (including the new fallback rates and spread adjustments that will be published by Bloomberg). However, there may be certain terms that the parties wish to include or amend. Some examples of terms which parties may wish to modify include the following:

• If the Amended Definitions do not include a pre-cessation trigger event, it is possible that parties will want to include one through bilateral amendment.

• Parties may wish to make revisions to the ISDA fallback provisions necessary to address certain administrative and technical issues applicable to the particular terms of their agreement, such as changes related to determination dates, calculation agents and payment dates.²⁴

Because of the continually developing array of issues relating to the IBOR transition and the difficulty in capturing all possible reasons that parties may choose to amend their contracts bilaterally rather than enter into the Protocol, the ARRC urges Treasury and the IRS to provide flexible relief with respect to such bilateral incorporation of contractual language comparable to the ISDA fallback provisions.

II. Application of Proposed Regulations to Protocol and Amended Definitions and Request for Targeted Guidance

This section discusses the reasons why the Proposed Regulations do not clearly apply to the Protocol and Amended Definitions, and describes the ARRC's requested relief.

a. The Proposed Regulations, the Protocol and the Amended Definitions

The application of the Proposed Regulations to certain modifications of contracts to adopt or modify a fallback provision, including by adherence to the Protocol or bilateral adoption of the Amended Definitions, may be unclear in certain respects. In particular, the Proposed Regulations provide that no exchange occurs for purposes of Section 1001 of the Code as a result of an amendment to a debt instrument or modification of a non-debt contract to (1) include a qualified rate as a fallback to a rate referencing an IBOR or (2) to replace an IBOR fallback rate with a qualified rate and, in either case, any associated alterations or modifications.²⁵ A rate is a qualified rate if it satisfies three requirements: (1) the rate is one of a series of enumerated rates, which includes SOFR, (2) the fair market value of the debt instrument or non-debt contract after the alteration or modification is substantially equivalent to the fair market value of the debt instrument or non-debt contract before the alteration or modification or one of the associated safe harbors is met (the “fair market value requirement”), and (3) the replacement rate is based on transactions in the same currency as the IBOR.²⁶

The ARRC expects that the amendments to be made pursuant to the Protocol, or comparable bilateral amendments, will satisfy most of the requirements set forth in the Proposed Regulations as a predicate to relief thereunder. For example, the ARRC expects that the new fallback rates will generally fall into the enumerated list of qualified rates included in the Proposed Regulations²⁷ and that the administrative changes made by the ISDA fallback provisions will qualify as “associated alterations or modifications.”²⁸ However, it is not clear whether an amendment made through adherence to the Protocol will satisfy the fair market value requirement.

The preamble to the Proposed Regulations states that the purpose of the fair market value requirement is to ensure that the modifications are limited to those necessary to replace the IBOR with a new reference rate. However, the preamble acknowledges that fair market value may be difficult to determine precisely and therefore the Proposed Regulations provide two safe harbors in order to ease compliance. Under these safe harbors, the fair market value requirement is deemed satisfied if either (1) the historic average of the IBOR and replacement rate are within 25 basis points of each other, taking the spread adjustment into account or (2) the parties are unrelated and determine, based on arm's-length negotiations, that the fair market value of the debt instrument or non-debt contract is substantially equal before and after the alteration or modification.²⁹

The existing safe harbors in the Proposed Regulations may not be available to taxpayers who adhere to the Protocol or adopt the Amended Definitions through bilateral agreement. The historic average rates safe harbor requires that, as of the date of the alteration or modification, there be no more than a 25 basis point difference between the historic average of the IBOR and historic average of the replacement rate, taking into account any spread adjustment, as of the date of the modification of the contract.³⁰ The historic average may be determined using an industry-wide standard, including one recommend by ISDA or the ARRC for purposes of computing the spread adjustment. Alternatively, the historic averages may be determined using any reasonable method that takes into account every instance of the relevant rate published during a continuous period that begins no earlier than 10 years before and ends no earlier than three months before the modification. However, the ISDA fallback provisions included in the Amended Definitions will establish the spread adjustment using a historical period ending on the day before the trigger event date, not the modification date, and therefore the ISDA fallback provisions do not clearly fit within the confines of the safe harbor. Importantly, as described above, the trigger event date will occur sometime (generally unknown) after the date a contract is modified.

Taxpayers adhering to the Protocol also cannot clearly satisfy the second safe harbor, which requires arm's-length negotiations, because the Protocol is designed so that the parties do not negotiate directly. Instead, when both parties to a derivative adhere to the Protocol, the terms of the contract are automatically amended to include the Amended Definitions incorporated into the Protocol. However, while amendments to a derivative contract made through adherence to the Protocol do not involve negotiation between the parties to the contract, the underlying policy goals of this safe harbor — agreement among unrelated market participants — would seem to be met. Specifically, the terms of the Amended Definitions have been determined through a market-wide negotiation of sorts that has included regulators, trade organizations and market participants from numerous sectors and countries.³¹

It is possible that the fair market value requirement may be satisfied without the use of a safe harbor (i.e., under the “general test”). However, satisfaction of the general test would require a valuation for each contract modified (either through the Protocol or bilaterally) to include the Amended Definitions. It is important to provide certainty to market participants that adherence to the Protocol or bilateral agreement to include contractual provisions comparable to the Amended Definitions does not cause a taxable exchange to occur for purposes of Section 1001 of the Code, without the need for such valuations.

For the reasons described above, taxpayers adhering to the Protocol or adopting the Amended Definitions through bilateral agreement cannot be certain they will meet the fair market value requirement or come within one of the safe harbors and therefore avoid a taxable exchange. This uncertainty may deter parties from adhering to the Protocol or adopting the Amended Definitions, in particular during the Initial Adherence Period.

b. Requested Guidance

The ARRC requests that Treasury and the IRS issue standalone guidance stating that adherence to the Protocol, as well as bilateral modifications that implement comparable fallback provisions, will not give rise to a taxable event under Section 1001 of the Code. As noted above, the ARRC intends to provide additional comments regarding the Proposed Regulations, including comments addressing the impact of the fair market value requirement in other contexts, but is prioritizing these comments because it understands that the publication of the Protocol is likely to precede the finalization of the Proposed Regulations. Such standalone guidance could be in any form, provided that taxpayers can rely on it.

While the ARRC believes that broad adherence to the Protocol is a critical goal and that such adherence will best facilitate the adoption of more robust fallback provisions into an inordinately large number of legacy derivative contracts, it understands that there are legitimate and commonplace reasons why significant numbers of market participants may choose to enter into comparable contractual modifications on a bilateral basis. Accordingly, the ARRC recommends that the standalone guidance also apply to modifications of contracts that are comparable to the modifications effected by adherence to the Protocol.

The ARRC believes that the nature of the Amended Definitions and the Protocol should allay those concerns of Treasury and the IRS that motivated certain of the predicates for relief under the Proposed Regulations, including the fair market value requirement, and therefore such concerns should not impede the issuance of prompt and broad relief.

The Amended Definitions are intended to be adopted widely by the global market, and are expected to be the industry standard fallback provisions for both bilateral and cleared derivatives, and potentially other types of contracts. They have been developed by ISDA, at the request of international regulators, based on extensive consultations with global market participants and reflect the views of a variety of participants. In addition, both the applicable rate and the spread adjustment will be calculated and published by Bloomberg based on predetermined formulas.

Because the methodology for calculating the spread adjustment will utilize data as of the trigger event date, which is an unknown date in the future, parties adhering to the Protocol (or entering into comparable bilateral amendments) during the Initial Adherence Period will not be able to predict whether the spread adjustment resulting from the ISDA fallback provisions will operate to their economic benefit or detriment. In addition, because adhering to the Protocol results in a modification of all of the adhering party's ISDA Master Agreements with other adhering parties and modification of an ISDA Master Agreement will generally amend multiple individual derivative transactions, an adhering or amending party will likely modify both “long” and “short” contracts, with the result that the economic consequences of these modifications will not be known at the time of adherence.

The Amended Definitions and the Protocol do not take into account the individual circumstances of any specific contract and therefore cannot include any changes that are unrelated to the incorporation of the more robust ISDA fallback provisions. Accordingly, where a modification is solely to adopt the Amended Definitions or comparable contractual provisions, whether through adherence to the Protocol or by bilateral amendment, the concern that the parties will agree to other changes, unrelated to the replacement of an IBOR, simply does not apply. As a result, the fair market value requirement represents an undue barrier to these types of modifications.

While the technical discussion herein focuses principally on the fair market value requirement because it presents a clear impediment to relief under the Proposed Regulations in this context, the ARRC believes that standalone guidance regarding the Protocol and the Amended Definitions should apply broadly and not address the fair market value requirement alone. Such broad guidance would eliminate any uncertainty market participants may otherwise have that adherence or amendment may trigger taxable events, uncertainty that could unnecessarily hinder adherence.

Accordingly, the ARRC requests interim guidance that would state that the modification of a contract, either through adherence to the Protocol or the entry into comparable bilateral modifications, is not a taxable event under Section 1001 of the Code. In order to reduce impediments to timely adherence to the Protocol or adoption of the Amended Definitions, the ARRC urges Treasury and the IRS to provide such guidance as soon as possible and in any case by February 2020.

c. Proposed Language

Attached to this letter as Appendix A is draft language that could serve as the basis for the guidance requested herein.