United States: REVERSEinquiries: Volume 1, Issue 4

Structured And Market-Linked Product News For Inquiring Minds

The ARRC Releases its Guiding Principles for new LIBOR Fallbacks

On July 9, 2018, the Alternative Reference Rates Committee (the "ARRC") announced voluntary guiding principles for market participants to use in developing new LIBOR fallbacks for cash products, which include USD LIBOR floating rate notes.1

As we discussed in an earlier article in this publication, issuers of floating rate notes have begun to adjust their LIBOR fallback mechanisms to avoid having their floating rate notes default to fixed rate notes when LIBOR ceases to be published in 2021.2 Some of the issues we discussed in our article are covered in detail in the ARRC announcement: the need for an exact definition of what constitutes a LIBOR cessation, the use of a substitute rate, adjustments to the substitute rate to account for the various LIBOR tenors and the extent of discretion allowed to the entity that chooses the substitute rate or makes necessary adjustments to that rate.

We summarize the points in the ARRC announcement below and raise a few questions.

It's time to get your head out of the sand. At this point, issuers should have some improved fallback language in place. The process will be iterative, and issuers should be willing to adjust their disclosure over time until "absolutely the most robust language possible has been identified."

The goal is uniform precision. More flexibility and discretion may be used in the beginning of the process, with a view to moving toward more specific language that removes ambiguity as to how fallbacks and adjustments will be selected. As a market consensus emerges on the key items (i.e., specific triggers, the successor rate, the spread adjustment mechanism, and the term structure), then disclosures should become more uniform and eliminate unnecessary variations. Limited discretion minimizes opportunities for dispute.

No mavericks. Draftspersons should keep an eye out for what is developing in other asset classes; for example, loans and derivatives. Revised fallback mechanisms for LIBOR floating rate notes should not be drafted in a vacuum.

Yes, SOFR is the new rate. The secured overnight financing rate ("SOFR") or a benchmark based on SOFR should be the replacement rate for LIBOR where appropriate and practicable.

No more polls. Stating the obvious, the ARRC discourages market participants from relying on the existing LIBOR fallbacks, which create the illusory situation of calculation agents calling up banks to get quotes for rates in a situation where a rate based on quotes was not published.

Where's the beef? The ARRC release states that "[m]echanics for determining successor rates, spread adjustments and term structures should be feasible from an operational perspective."

Agreed. The adjustment to move from a forward-looking term rate (LIBOR) to a backward-looking secured rate (SOFR) is the missing piece of the LIBOR replacement puzzle. According to published reports, this adjustment will not be fully determined until late 2021, just in time for LIBOR cessation. The ARRC release notes that market participants should understand "how any successor rate may behave relative to LIBOR in different stages of the economic cycle and in different economic conditions."

The ARRC release does not address the complexity of building an adjustment mechanism that will allow SOFR to behave like LIBOR in normal and stressed environments. Although SOFR with an adjustment may track a LIBOR tenor in a normal market, there may be a divergence in stressed economic conditions. That raises the question of how will "stress" be defined and how will a spread be triggered? Who will determine the parameters?

The ARRC release does state that the fallback language "should explicitly allow for a spread adjustment to minimize valuation changes" and that the calculation agent or similar entity making the adjustment should be adequately protected in making any determinations.

Future failure. The ARRC release recommends that draftspersons make the new fallbacks "future proof"; i.e., address a potential cessation of the replacement rate.

The rate formerly known as LIBOR. Assuming that SOFR has a successful run over the next few years and quants have come up with a workable risk spread adjustment and term structure, by 2021 the market will have a new "risk-free" rate that walks and talks like LIBOR, but will operate under an assumed identity.

Coordination with global regulatory push to eliminate LIBOR. While the ARRC release focuses on the details, both UK and U.S. officials are trying to drive LIBOR out of the picture. The UK Financial Conduct Authority Chief Executive Andrew Bailey characterized the current pace of the switch from LIBOR to a replacement rate as "not yet fast enough." Mr. Bailey noted in a recent speech that new LIBOR-based swaps contracts are still being written and introduced. In the same vein, David Bowman, a senior official at the Federal Reserve Bank, said that the stock of LIBOR-based contracts needed to be reduced.3

Broker-Dealer Sanctioned for Encouraging Early Resales of Structured Notes

On June 25, 2018, the Securities and Exchange Commission, or the SEC, announced that a broker-dealer settled charges relating to recommended resales of structured notes and certificates of deposit to retail investors between January 2009 and June 2013. According to the SEC's order (the "Order"),4 the SEC found that the broker-dealer generated substantial fees by improperly encouraging retail customers to trade structured notes prior to their maturity dates, even though the structured notes were intended to be held to maturity. Representatives of the broker-dealer recommended that customers sell their outstanding notes before maturity and invest the proceeds in new notes, generating fees for the broker-dealer and reducing the customers' returns.5

The SEC determined that the broker-dealer's representatives did not reasonably investigate or understand the significant costs of their recommendations and that their supervisors routinely approved these transactions despite internal policies prohibiting short-term trading of the notes. The Order recognizes that the broker-dealer took remedial steps to address the allegedly improper sales practices.

MARK-UPS AND MARK-DOWNS LIMITING RETURNS

Structured notes are priced with embedded costs, or "mark-ups," including selling commissions and structuring and hedging costs. These costs, disclosed in each offering document, result in the estimated initial value of each note being less than its purchase price on the pricing date. There are also costs associated with redeeming notes prior to maturity. Prior to September 2011, the broker-dealer's representatives could charge a sales commission on early redemptions, with supervisor approval. Furthermore, the price at which the broker-dealer was willing to buy back the notes was typically lower than the current value of the note. This "mark-down" was typically between 2% and 3%. The mark-downs on sales of outstanding notes prior to maturity coupled with the mark-ups on purchasing new notes ate away at the customer's potential gains.

OTHER OBSERVATIONS

Churning. For the last several years, the SEC's Enforcement Division has been focused on churning, (i.e., multiple transactions switching between products within a short period of time), and the potential costs to investors. In many of the cases described in the Order, a substantial number of the broker-dealer's exchanges involved notes linked to similar or identical referenced assets. For example, a note linked to the S&P 500® was resold and the proceeds were used to purchase a note linked to the Dow Jones Industrial Average®.

Offering Documents versus Recommendations. According to the offering documents, these notes were not suitable for short-term trading due to their limited liquidity. The disclosure stated that these products were "buy-and-hold" products and should be held until maturity. This stated strategy was inconsistent with recommendations by the broker-dealer's representatives.

"Locking in Gains." Certain representatives justified the exchanges by claiming that that customers were "locking in gains" on their original notes, capturing gains rather than risking a decline in the performance of the reference asset. In many instances, there was limited value in locking in gains. Due to principal protection and the note's appreciation, the only amount reasonably at risk in the original note was the gain to date. In addition, due to mark-downs on early redemptions, the customer had to sacrifice a significant portion of the gain. Further, because principal protection only applied if the note was held to maturity, a new note would only be expected to outperform the original note if held to maturity.

Supervision. The Order points out that a certain representative's supervisors and regional compliance managers approved these transaction without understanding the economics of the transaction and strategy. The broker-dealer's compliance personnel were aware of the representative's recommendations, but failed to limit the practice. The representative never received any guidance from supervisors or compliance personnel regarding the practice of soliciting customers to exchange their notes.

Two-in-a-million? The SEC focused its Order on the practices of two individual representatives of the broker-dealer and noted that most of the broker-dealer's representatives only infrequently engaged in soliciting these exchanges.

Changes in Procedure. The trades in question occurred prior to June 2013, demonstrating the broker-dealer's efforts to prevent these types of trades. Generally, broker-dealers have been working over the past several years to improve their compliance and supervision procedures.

Bad behavior results in CDs being treated as securities? CDs are generally treated as bank deposits that are not subject to the securities laws under Marine Bank v. Weaver, 102 S.Ct. 1220 (1982). However, at least one court has characterized CDs as securities subject to the requirements of the federal securities laws due to the particular facts of that case, which resulted in the instruments being considered "investment contracts." In Gary Plastic Packaging Corporation v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 756 F.2d 230 (2d Cir. 1985), the CDs in question were determined to be investment contracts due to the fact that their value largely depended upon the efforts of others (i.e., the court considered that the dealer in Gary Plastics promised to, and did, maintain a secondary market in the CDs). In footnote 4 to the Order, which was placed at the end of a sentence noting that the representatives "engaged in a systematic practice of soliciting customers to engage in [structured notes and CDs] exchanges on hundreds of occasions," the SEC appears to reference Gary

Plastics in stating that the CDs described in the Order were "investment contracts, and therefore securities." The SEC explained that the activities of the representatives, working with the dealer, constituted making and maintaining a market for the CDs, resulting, under a Gary Plastics analysis, in the CDs being treated as investment contracts, which are securities. This would be an unusual outcome, and it is not clear whether the footnote resulted from a thorough analysis of the circumstances.

CONCLUSION

The Order serves as a reminder to broker-dealers to review existing policies and practices regarding early redemption of structured products. Policies should indicate the circumstances under which trades prior to maturity may be appropriate and representatives should be trained accordingly. Compliance personnel should also be trained and review whether these transactions are appropriate under the circumstances.

Broker-dealers should ensure that their oversight and surveillance procedures track the occurrence of these transactions and the incidence of such transactions with respect to individual representatives.


To read this Newsletter in full, please click here.


Footnotes

1. The ARRC Guiding Principles can be found at: https://goo.gl/eppZRt.

2. Our earlier article on replacing LIBOR fallback mechanisms can be found at: https://goo.gl/XYuESX.

3. See "Global Regulators Push for Faster Transition Away From LIBOR," Wall Street Journal (July 12, 2018).

4. The Order may be found at https://goo.gl/tKmvWv.

5. The Order relates to activities relating to sales of structured notes and certificates of deposit ("CDs"), but for the sake of brevity, we only refer to structured notes in this article.

Originally published 16 July 2018

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© Copyright 2018. The Mayer Brown Practices. All rights reserved.

This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

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