As a result of the well-publicized scandals involving LIBOR rate manipulation, British regulators announced plans in July 2017 to phase-out LIBOR by 2021 and replace it with a more reliable benchmark.  In addition to other markets, the LIBOR phase-out will have a broad impact on the $4 trillion syndicated loan market, including currently existing loan documents that extend past 2021.  Specifically, in the case of loan documents that reference a LIBOR rate and automatically fall back to prime or base rate if LIBOR is unavailable, the permanent phase-out of LIBOR will likely lead to the imposition of a higher interest rate if this fallback language is not amended.  However, because LIBOR’s replacement has not yet been determined and the phase-out is at least three years away, it is probably premature at this time for borrowers to proactively seek amendments to their credit agreements.  That being said, there are a few steps that borrowers can take now to be prepared.

BACKGROUND

The London Interbank Offered Rate (LIBOR) has been the global borrowing interest rate benchmark for nearly 50 years.  Many borrowers pay interest under their credit agreements based upon a LIBOR interest rate, which is typically defined first by reference to the screen rate published by ICE Benchmark Administration Limited (IBA), and then to an alternative reference source if the screen rate is unavailable.  Although the LIBOR rate is intended to represent the rate of interest at which major banks in London actually loan funds to each other, the financial crisis liquidity in the LIBOR market has dropped significantly to the point where more than 70% of 3-month LIBOR submissions are based on the judgment of the submitting bank as opposed to actual transactions.  Due to this lack of liquidity and the negative publicity surrounding the LIBOR scandal, the United Kingdom Financial Conduct Authority (FCA), which has regulated LIBOR since April 2013, urged the phase-out of LIBOR by the end of 2021 and a transition to an alternative reference rate based on market transactions.

The uncertainty surrounding LIBOR’s fate is twofold.  First, although the FCA has encouraged the phase-out of LIBOR, it has stressed that the phase-out is not mandatory and, further, that the IBA may continue to produce LIBOR rates after 2021 if it chooses to do so.  Because of this, some commentators believe that LIBOR may continue to be quoted well beyond 2021 side-by-side with LIBOR’s replacement.  Second, the FCA has put the burden of finding LIBOR’s replacement primarily on market participants, who have not yet settled on an alternative rate.  The front runners at this point appear to be the Broad Treasury Financing Rate (BTFR) in the U.S., and the Sterling Overnight Index Average (SONIA) in the U.K., each of which is being considered as a replacement rate in the derivatives market.  However, neither of these rates are ready replacements for LIBOR in the lending market because (i) each is an overnight rate as opposed to LIBOR, which is quoted for seven borrowing periods ranging from overnight to one year, and (ii) each is based on past transactions (i.e., each is “backward looking”) as opposed to LIBOR, which is a stated rate for a forward-looking term.

WHAT BORROWERS CAN DO TO PREPARE

The first thing borrowers can do is review their existing credit agreements to see how the interest rate is determined if LIBOR no longer exists.  Although some credit agreements, such as the LSTA and LMA models, contain provisions that fall back to a waterfall of alternative reference rates if LIBOR is unavailable, such as a reference bank rate (i.e., an average of quotes of rates in the wholesale markets), the lenders’ cost of funds, or an alternative rate, many do not contain any fallback other than to simply default to base or prime rate loans.  As these rates are historically higher than the LIBOR rate, they can lead to the borrower incurring a significantly higher interest expense than it anticipated at the time the borrower entered into the loan.  However, even if a borrower is faced with a potential rate increase, given the uncertainty of both the timing of LIBOR’s phase-out and the replacement for the LIBOR rate, it is probably premature for it to approach its lender seeking an amendment.

If a borrower sees a potential issue with its LIBOR fallback language, it should closely monitor the marketplace to determine when and if it needs to take action.  Given the magnitude that LIBOR’s phase-out will have on the loan market, it is highly unlikely that the market will not do all that it can well in advance of the phase-out to effectuate a smooth transition to an alternative standard.  In particular, it is likely that LIBOR’s replacement will be determined well in advance of 2021 so borrowers can assess the impact on their credit agreements and be prepared to take appropriate action (e.g., seeking an amendment or prepaying the loan).  Further, it is also likely that the FCA will have signaled whether it will continue to quote LIBOR after the phase-out and, if so, for how long.  Depending on the length of time FCA continues to do so, borrowers with loans that mature past 2021 may be able to avoid amending their agreements entirely.  Finally, by the time the phase-out is implemented, the market will have likely settled on a standard for appropriate LIBOR fallback language, which should then be much easier to incorporate into existing loan documents than starting from scratch.  In short, although the temptation as a borrower may be to get ahead of the potential problem by proactively seeking an amendment, the best course of action is to monitor the situation and take a wait-and-see approach. One caveat to this is the situation where a borrower is already in the process of amending its credit agreement for other reasons, in which case it may as well amend the LIBOR fallback provision since the marginal cost of doing so is minimal.

 

Not too long ago, technology was considered a “vertical” market filled with companies that met the needs of the “technology” industry (think Microsoft, Dell, Cisco, Intel, and IBM).  However, technological products and services have evolved to the point of serving a “horizontal” market, having become an important aspect of many different types of businesses across a wide variety of industries and sectors (think fintech, healthtech, cleantech, autotech, edtech, etc.) and, by extension, M&A transactions.

For example, deals in the media industry increasingly are focused on the digital media aspects, particularly given the decline in demand for print media.  Likewise, parties to acquisitions in the financial services industry often pay close attention to the protection of proprietary investment strategies, data protection, trade names, and customized software.  Even manufacturers and other traditionally “non-tech” companies are leaning on technology more and more in order to streamline their business processes, manage and analyze data better, and to protect themselves from cyber-attacks.

This trend towards a “horizontal” market only looks to accelerate as technology becomes more and more embedded in businesses of all stripes, as presaged by the $13.7 billion purchase of Whole Foods by Amazon.com Inc. this year.  Similarly, private equity interest in tech and tech-enabled businesses has grown in recent years, particularly for more “stable” businesses such as software companies that generate recurring revenue or that serve other businesses.

Given the growing proportion of M&A deals that are considered to be “tech” deals (even where non-technology companies are involved), middle market businesses of all kinds that are evaluating the possibility of a sale or, conversely, looking for potential targets to acquire cannot afford to overlook the importance of technology as a key asset.

High-level legal concerns often revolve around the target’s ownership or right to use key technological assets, as well as the level of protection and ability to transfer the same.  This includes making sure that all owned intellectual property of the business is properly registered with the USPTO or copyright office in the name of the appropriate entity, and that all renewals and maintenance fees have been paid.  Additionally, acquirers should check that employees and, particularly, key independent contractors of the target have assigned their rights in and to all key intellectual properties to the target.  Inbound licenses that are material to the business, as well as revenue generating outbound licenses, should be reviewed to determine assignability.  It goes without saying that it is critical to ascertain whether the target has any existing or suspected infringement claims, as well as any security interests or encumbrances affecting its key technology assets.

Further, to the extent key technologies are held within a joint venture between the target and a third party, an acquirer should consider whether its business model would allow it to “step into the shoes” of the target vis a vis the joint venture versus the extent to which the acquirer could readily extract the technological assets and/or wind-down the joint venture.

The takeaway here is when engaging in M&A transactions – whether in the middle market or otherwise – ignore technology at your peril.  Those companies (even “non-tech” ones) that can demonstrate a strong command of their technological assets should increase their attractiveness as targets as we move into the future.  Conversely, acquirers that understand their own technology “gaps,” can quickly assess the target’s key technological assets and grasp how such assets will improve the integrated business post-closing will be better positioned to focus their due diligence efforts, minimize indemnification risks, and ultimately achieve the intended synergies.

New York entrepreneurs in the virtual currency space must be careful to follow New York’s licensing requirements enacted under Financial Services Law Sections 102, 104, 201, 206, 301, 302, 309, and 408. Under the new regulations issued by the New York State Department of Financial Services, a business that engages in “Virtual Currency Business Activity” must be licensed by the New York State Department of Financial Services.  A business is engaged in Virtual Currency Business Activity if it:

  1. receives virtual currency for transmissions or transmits virtual currency;
  2. stores, holds, or maintains custody or control of virtual currency on behalf of others;
  3. buys and sells virtual currency;
  4. exchanges or converts something of value, into virtual currencies; or
  5. controls, administers, or issues a virtual currency.

However, businesses chartered under New York Banking Law and “approved by the superintendent to engage in Virtual Currency Business Activity,” as well as “merchants and consumers” that use virtual currencies for investment purposes or to buy and sell goods or services are exempt from the licensing requirement.

The license application fee to register as a business engaged in Virtual Currency Business Activity is $5,000.00 and is nonrefundable.  The application must include:

  1. the exact name of the applicant, including any doing business as name;
  2. a list of all of the applicant’s affiliates and an organization chart illustrating the relationship among the applicant and such affiliates;
  3. a list of, and detailed biographical information for, each individual applicant and each director, principal officer, principal stockholder, and principal beneficiary of the applicant;
  4. a background report prepared by an independent investigatory agency for each individual applicant, and each principal officer, principal stockholder, and principal beneficiary of the applicant, as applicable;
  5. for each individual applicant; for each principal officer, principal stockholder, and principal beneficiary of the applicant, as applicable; and for all individuals to be employed by the applicant who have access to any customer funds, whether denominated in fiat currency or virtual currency: (i) a set of completed fingerprints, or a receipt indicating the vendor (which vendor must be acceptable to the superintendent) at which, and the date when, the fingerprints were taken, for submission to the State Division of Criminal Justice Services and the Federal Bureau of Investigation; (ii) if applicable, such processing fees as prescribed by the superintendent; and (iii) two portrait-style photographs of the individuals measuring not more than two inches by two inches;
  6. an organization chart of the applicant and its management structure;
  7. a current financial statement for the applicant and each principal officer, principal stockholder, and principal beneficiary of the applicant, as applicable, and a projected balance sheet and income statement for the following year of the applicant’s operation;
  8. a description of the proposed, current, and historical business of the applicant;
  9. details of all banking arrangements;
  10. all written policies and procedures required by, or related to, the requirements of this part;
  11. an affidavit describing any pending or threatened administrative, civil, or criminal action, litigation, or proceeding before any governmental agency, court, or arbitration tribunal against the applicant or any of its directors, principal officers, principal stockholders, and principal beneficiaries, as applicable;
  12. verification from the New York State Department of Taxation and Finance that the applicant is compliant with all New York State tax obligations in a form acceptable to the superintendent;
  13. if applicable, a copy of any insurance policies maintained for the benefit of the applicant, its directors or officers, or its customers; and
  14. an explanation of the methodology used to calculate the value of virtual currency in fiat currency; and

Businesses operating in the virtual currency space, that are not exempt from these new regulations, must ensure that they comply with these new licensing requirements. Businesses interested in pursuing a New York virtual currency license should consult with legal counsel.

 

Contractors, advisers, and employees (collectively, “Service Providers”) who receive property that is non-transferrable or subject to a substantial risk of forfeiture must generally defer their income recognition until those conditions no longer apply. However, due to the potential appreciation in the property (for example, in value of start-up equity) the ordinary income ultimately recognized could be significantly greater than the initial value. The Service Provider may be able to significantly reduce their taxes, and the employer may create a significant compensation incentive, if the Service Providers make the election under Internal Revenue Code Section 83(b) to recognize the income currently, notwithstanding the forfeiture risks. Timing of this election is critical as it must be made within 30 days after the property is transferred to the Service Provider.

Under Internal Revenue Code 83(a), Service Providers who receive property (including equity interests) for their services that are non-transferrable or subject to a substantial risk of forfeiture are required to pay, at the date the interests vest, income tax on the excess of the fair market value of the property over the amount paid for the property. If the fair market value of the property increases between the grant and vesting of the interests, Service Providers will pay an income tax on the greater value, and possibly at a higher marginal rate too. A Section 83(b) election may be the perfect tool for Service Providers to convert immediate ordinary income into deferred long term capital gains.

The downside of the election is that the income is recognized even though the risk of forfeiture still exists. If the risk materializes and the property goes down in value, or becomes worthless, there is no deduction to the Service Provider. They are stuck with paying income tax on property that is potentially worthless.

These risk/reward tradeoffs highlight the advantage of using this election for compensating employees of start-up ventures, typically with equity subject to vesting. In this case, the current value of the equity is limited, so there is little or no income to report (and pay tax on) currently. If the equity goes down in value, or is forfeited, the employee has not wasted tax payments. However, if the equity increases in value, as the parties hope, then the employee will be able to report this value at the more favorable capital gains rates instead of ordinary rates. The Section 83(b) election can make a start-up equity grant a much more effective inducement to attract new employees, by putting more money into the pocket of the employee.

But remember, taking advantage of the Section 83(b) elections requires a filing by the Service Provider within 30 days after the grant of property. The law does not want to allow the Service Provider to see which way the value is moving. The election, and the commitment to property must be made up front.

Service Providers should contact an attorney or other tax professional when deciding whether or not to make a Section 83(b) election. Additionally, issuers and companies should contact Cole Schotz P.C. before granting equity or other compensation.

The SEC’s recently-adopted changes to Form ADV and Rule 204-2 of the Investment Advisers Act of 1940, as amended (the so-called “books and records rule”), raise important considerations for many private fund advisers – particularly those that also advise separately managed accounts or that manage multiple funds through affiliated entities.

In particular, the amendments will: (1) call for the collection of more specific information about advisers’ separately managed accounts (“SMAs”), (2) permit so-called umbrella registration on a single Form ADV for affiliated advisers that participate in a single advisory business, and (3) impose several new disclosure and recordkeeping obligations on advisers.

The SMA-related amendments include the following additional disclosure items:

  • Approximate percentage of SMA regulatory assets under management (“RAUM”) that are invested in 12 broad asset categories;
  • For advisors with at least $500 million in RAUM attributable to SMAs, the amount of RAUM attributable to SMAs and the dollar amount of borrowings attributable to those assets; and
  • Certain information about custodians that account for 10 percent or more of the adviser’s aggregate RAUM attributable to SMAs.

The umbrella registration-related amendments essentially modernize Form ADV to accommodate this form of registration and streamline the registration process consistent with the SEC’s position in the recent American Bar Association, Business Law Section, SEC Staff Letter (Jan. 18, 2012).  Note that these amendments do not extend to exempt reporting advisers and that certain conditions must be met in order for registered advisers to utilize umbrella registration, including:

  • The filing adviser and each relying adviser must advise only private funds and separately managed accounts in which the clients are “qualified clients”;
  • The relying advisers must be subject to examination by the SEC; and
  • The filing adviser and the relying advisers must operate under a single code of ethics and a single set of written compliance policies, and the procedures must be administered by a single CCO.

Separately, the amendments to Form ADV will call for new disclosures about advisers’ social media accounts, offices, and outsourced chief compliance officers (an area of recent focus by the SEC), among other things.

In conjunction with the amendments to Form ADV, the SEC also revised the books and records rule to require that advisers retain materials that demonstrate the calculation of performance or rates of return in any communications distributed to any person, as well as to maintain originals of all written communications received or copies of all written communications sent that relate to the performance or rate of return of managed accounts or securities recommendations.  Note that emails constitute “written communications” for these purposes.

Although the amendments to Form ADV and the revisions to the books and records rule do not go into effect until October 1, 2017, private fund advisers should consider what steps they should be taking now in order to be in a position to comply with these new requirements before the time comes.

The final rules are available here.