Introduction
On March 15, 2020, citing the disruption in economic activity as a result of the COVID-19 outbreak, the Federal Open Market Committee (FOMC) lowered the target federal funds rate (the target rate set by the FOMC to implement monetary policy) to 0 to 0.25 percent, its lowest rate since December 2015. And in a flight to quality, on March 25, 2020, the yields (though not the coupons) on one-month and three-month US Treasury bills fell below zero for the first time since 2015.
While those yields suggested the possibility of negative rates, the FOMC has never imposed them, and Jerome Powell, Chairman of the Federal Reserve, said recently that negative borrowing costs are not likely to be appropriate policy for the US. Such rates, however, are not uncommon in Europe and Asia. In mid-2014, for example, the European Central Bank (ECB) cut its deposit facility rate (DFR) to -0.10, becoming the first major central bank to implement negative interest rates as part of policy. Some European national central banks followed shortly thereafter, and the Swiss central bank, the SNB, currently charges commercial banks -0.75% to maintain deposits at the bank. Similarly, in early 2016, the Bank of Japan began imposing a negative interest rate on reserves that financial institutions deposit at the bank. The policy underlying these decisions is relatively simple: negative interest rate policies effectively penalize banks for depositing their excess funds with their central banks and are designed to encourage banks to lend their capital into the economy.
Considerations for Managing Negative Interest Rates
The ultimate goal underlying a negative interest rate policy for a central bank is to promote economic growth and manage inflation. However, this policy may impact various features of credit instruments and related agreements in ways that lenders, borrowers, and other loan and swap market participants must understand.
Floating Rates and Loan Repricing. Most directly, negative interest rates affect the re-pricing of floating rate loans, whose rates are often computed some number of basis points above or below a base rate. Many European benchmark rates have been in negative territory for years. Swiss franc LIBOR, for example, a base rate often used for Swiss franc-denominated loans, has been negative for over five years as a result of policy decisions by the Swiss National Bank, while SARON (Swiss Average Rate Overnight), its designated IBOR replacement, is also negative. Euro LIBOR, another commonly used base rate, has also regularly been negative since 2015, especially for shorter maturities, and Euribor rates (a reference rate for euro-denominated forward rate agreements, short-term interest rate futures contracts, and interest-rate swaps) have also been negative, as have Eonia (Euro Overnight Index Average) and its replacement, €STR (Euro Short-Term Rate).
Operational Concerns. Negative interest rates raise a series of operational issues that both lenders and borrowers would need to consider. Banks have reported that their accounting and operating systems often do not contemplate negative interest rates. Negative interest rates do not, for instance, permit straightforward responses in bank accounting systems to queries regarding a loan's rate of interest; how and whether accruals should be calculated or accounted; and how "interest" on such a loan should be invoiced, if at all. A bank already implementing systems changes for a post-LIBOR environment should also consider whether it's systems can also account for negative interest rates on both sides of the balance sheet.
Contract Interpretation
Financing Agreements. When loan documents that include benchmark-based rates do not provide an express "floor" with respect to the benchmark, questions may arise regarding the appropriate method for determining the relevant interest rate and relevant interest rate margins in an environment where the benchmark rate is negative. While we are not aware of any New York jurisprudence in this regard, at least one court1 in the United Kingdom, interpreting an English-law governed ISDA Master Agreement and Credit Support Annex entered into before ISDA published its Collateral Agreement Negative Interest Protocol, determined that negative interest was not required to be paid, pointing to, among other factors, the lack of any mention in the documentation of negative interest as "a powerful indicator that it was not contemplated as payable."
A common drafting solution to the negative interest rate question is to include a "zero floor" with respect to LIBOR-based rates that are included in the loan documentation. Language can be added to the LIBOR-based rate definitions to clarify that the relevant reference rate would never fall below zero (such as, "provided, however, that in the event LIBOR is less than zero, LIBOR shall be deemed to be zero."). This drafting option is contemplated in model documentation of the London-based Loan Market Association (LMA) and of the New York-based Loan Syndication Trading Association (LSTA), as well as in the model language recently suggested by the Alternative Reference Rates Committee (ARRC), the industry group developing a replacement benchmark rate for USD LIBOR (SOFR, the secured overnight financing rate). Before including such language, however, parties in countries with exchange and similar controls should ensure that, in any required transaction registration with the central bank or similar authorities, appropriate notation is made and regulators consulted, as local systems may not contemplate interest rate floors or the possibility of negative interest rates.
Deposit Account Agreements. Similarly, bank deposit account agreements often do not contemplate a negative interest rate environment. Accordingly, depository institutions should review their account agreements and disclosures to address the prospect of negative rates. For consumer accounts, institutions will need to bear in mind that applicable law often requires advance notice be given prior to a change that may be viewed as negatively impacting the depositor.
Commercial and Other Non-Financing Agreements. Many non-financial contracts also include references to LIBOR or another benchmark interest rate, especially in clauses pertaining to post-closing matters, late payments, or liquidated damages. For example, an asset or stock purchase agreement may use a benchmark to calculate post-closing adjustments, while a commercial sales contract may do the same for interest on late payments. Although these contracts often do not include a spread over the benchmark, they also rarely include an interest rate floor. In such situations, a negative interest rate could effectively frustrate the purpose of the clause.
Regulatory Treatment. In drafting solutions to the negative interest rate problem, parties should be alert to the potential for unintended regulatory consequences. For example, although many types of loans and commercial agreements are not considered "swaps," parties may inadvertently introduce swap treatment into their documents via inappropriate incorporation of certain forms of interest rate locks, caps, or floors.2 In the United States, following the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act and implementing regulations issued by the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC), agreements and transactions are considered swaps or security-based swaps depending on, among other things, their payment terms and whether payments are linked to the values of rates, securities, indexes, or commodities.3 The risk of not properly characterizing or defining a floor rate can be significant, because swaps are subject to numerous reporting, recordkeeping, business conduct, and other requirements. Further, after certain transaction thresholds are reached, a firm may become subject to CFTC or SEC registration, capital, and governance standards. Parties may be able to avoid swap or security-based swap treatment by careful drafting when creating a rate floor structure.
Tax Issues. There is no authority addressing how negative interest is treated for US federal income tax purposes, which leaves some unanswered questions. For US federal income tax purposes, the term "interest" generally is defined as an expense incurred for the use of money. In the context of a deposit with a bank that incurs negative interest (i.e., where the depositor pays the bank a periodic amount to deposit funds with the bank), the amount paid by the depositor does not easily fit within the basic definition of "interest" for US federal income tax purposes because the depositor is not paying for the use of money. In such case, the amount paid by the depositor more closely resembles a fee for services because the depositor essentially is paying the bank to safeguard its funds.
In the context of a loan, a negative interest rate generally reduces the principal amount owed by the borrower to the lender. Although the tax characterization and timing is not entirely clear, it seems appropriate under US federal income tax principles that the borrower should have an ordinary income inclusion related to the negative interest. The deductibility by the lender of negative interest paid to the borrower, the timing and character of such a deduction, if permitted, also is unclear. Additionally, the US federal withholding tax obligations with respect to negative interest paid by a US lender to a non-US borrower similarly are uncertain.
To the extent negative interest becomes a reality in the United States, the US Internal Revenue Service may provide guidance in this area. Although not authoritative for US federal income tax purposes, we understand that certain foreign tax authorities have announced that negative interest is treated as interest for tax purposes that is deductible by the lender and includible as income to the borrower.
These tax issues and uncertainties will need to be considered and addressed when drafting and negotiating new or amended loan documents that may provide for negative interest. For example, parties may need to consider whether amending an existing loan document to provide for a floor rate creates a taxable event for US federal income tax purposes. A further business point that might arise is whether a lender would be required to "gross up" any principal reductions to account for potential borrower tax events, a circumstance generally not anticipated in standard loan documentation.
Hedging Issues. Negative interest rates also raise concerns with respect to interest rate swaps that are used to hedge a borrower's interest rate exposure on a floating rate loan that is subject to the "deemed to be zero" clause referred to above. Borrowers should be mindful of a potential mismatch between the floating rate specified in their loan and the floating rate provided for in their related swap.
In this regard, we note that interest rate swaps typically incorporate either the 2000 ISDA Definitions or the 2006 ISDA Definitions, both of which provide for the "Negative Interest Rate Method" and the "Zero Interest Method" to address negative interest rates. The Negative Interest Rate Method applies to an interest rate swap, unless the parties specify otherwise. Under the Negative Interest Rate Method, if the floating rate leg under the swap is negative, the borrower, instead of paying only the fixed leg of the swap, would also be obligated to pay the absolute value of the (negative) floating leg, while not receiving a corresponding payment from the lender under the loan. To avoid this mismatch, the parties may elect to apply the Zero Interest Rate Method, which provides that if the floating leg is negative, the floating rate payer is deemed to owe zero and the borrower is obligated to pay the fixed leg only. However, borrowers should be aware that electing to include this method will likely increase the price of the swap.
Negative interest rates may also affect cash collateral pledged as credit support for swap transactions. ISDA published its 2014 Collateral Agreement Negative Interest Protocol to permit counterparties to amend collateral agreements to account for negative interest amounts on cash collateral such that if an interest amount for an interest period is negative, the party pledging cash collateral pays the absolute value of that interest amount to the other party for that interest period. Swap counterparties should consider whether adherence to this protocol is appropriate for their collateral arrangements. (Note that the matter The State of the Netherlands v Deutsche Bank AG [2019] EWCA Civ 771 mentioned above was documented prior to the publication of the 2014 Collateral Agreement Negative Interest Protocol, though the English Court of Appeal discussed it in its opinion.)
Legacy Arrangements. Legacy agreements with interest rate provisions that predate a jurisdiction's negative interest rate policy may also pose a concern. If such agreements do not already contain an interest rate floor, a lender bank may wish to amend its agreements to clarify their intended economic treatment. However, in cases where a borrower will not agree to modify its agreement with the addition of a floor, lenders may wish to pursue other contractual remedies in the face of ambiguity or payment obligations triggered by negative interest rates.
Negative interest rate policies pose a number of operational and legal challenges for lending banks and counterparty borrowers. As central banks, including the United States' Federal Reserve, seriously consider implementing or extending such policies, parties may wish to implement forward-looking solutions to their agreements and review gaps in existing legacy agreements. Whether drafting solutions are implemented or not, parties would be wise to consider how negative interest rates impact their transaction economics and tax treatment to manage and/or hedge their exposure.
Footnotes
1. The State of the Netherlands v Deutsche Bank AG {2019} EWCA Civ 771.
2. See Further Definition of "Swap," "Security-Based Swap," and "Security-Based Swap Agreement"; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 Fed. Reg. 48208, 48246-48247 (Aug. 13, 2012).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
