Legislating for LIBOR’s cessation | Eversheds Sutherland (US) LLP

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On April 6, 2021, New York Governor Andrew Cuomo signed into law the New York State Legislature’s Senate Bill 297B/Assembly Bill 164B (the New York LIBOR Legislation)1, strengthening the groundwork for the forthcoming transition from US dollar LIBOR (formally known as the London Interbank Offered Rate) as the benchmark interest rate. The New York LIBOR Legislation is primarily intended for “tough legacy” contracts, securities and instruments governed by New York law that either lack fallback provisions or include ineffective fallback provisions in the event US dollar LIBOR is no longer published or representative. The New York LIBOR Legislation applies to tough legacy contracts that do not mature until after December 31, 2021 (in the case of the one-week and two-month US dollar LIBOR tenors), or June 30, 2023 (in the case of the overnight, one-month, two-month, six-month or 12-month US dollar LIBOR tenors)2. Notably, the New York LIBOR Legislation only applies to US dollar LIBOR and not to non-US dollar LIBOR transactions.

While the New York LIBOR Legislation is a welcome development, it does not necessarily resolve all of the issues faced by market participants in connection with their transition of all securities, loans and other instruments away from LIBOR. Contracts, securities and instruments governed by the laws of other states and countries that have not (yet) adopted changes to their laws equivalent to the New York LIBOR Legislation may still be problematic if they contain inadequate fallbacks. Moreover, the New York LIBOR Legislation may itself face challenges, including under federal law and the US Constitution. Current efforts to pass federal legislation akin to what was passed in New York but applicable in all 50 states and the District of Columbia, if successfully passed into law, may ameliorate many of the issues that relate to contracts governed by other states’ laws or that arise under federal law.3

A brief summary of the New York LIBOR Legislation and the current draft of federal legislation noted above, together with certain of the potential challenges that may be raised against the New York LIBOR Legislation’s enforceability, are set forth below.

I. New York LIBOR Legislation

The New York LIBOR Legislation amends the New York General Obligations Law by adding a new Article 18-c and mirrors a legislative proposal (the Proposal) drafted by the Alternative Reference Rates Committee (the ARRC) aimed at ensuring legal clarity for legacy instruments governed by New York law during the LIBOR transition.4

New Article 18-c provides, by operation of law, a replacement benchmark rate for agreements governed by New York law that use US dollar LIBOR but that (i) do not have any fallback provisions in place, or (ii) have fallback provisions that result in replacement rates that are in some way based on LIBOR. Under such circumstances, upon the occurrence of a “LIBOR Discontinuance Event” and the related “LIBOR Replacement Date” (each as defined in the New York LIBOR Legislation and discussed below), the then-current US dollar LIBOR-based benchmark used in determining the rate would, by operation of law, be replaced by a “Recommended Benchmark Replacement” based on the Secured Overnight Financing Rate (SOFR), which would include any spread adjustment and any benchmark replacement conforming changes selected or recommended by a “Relevant Recommending Body,” i.e., the Federal Reserve Board, Federal Reserve Bank of New York, or the ARRC or any successor thereto. In addition, if a contract, security or instrument includes US dollar LIBOR fallback provisions that allow or require one of the parties or an outsider to select a US dollar replacement rate for US dollar LIBOR, the New York LIBOR Legislation encourages such party or person to select the Recommended Benchmark Replacement by creating a safe harbor for such party or person if it selects the Recommended Benchmark Replacement.

The definitions of the terms “LIBOR Discontinuance Event” and “LIBOR Replacement Date” in the New York LIBOR Legislation generally align with the various definitions of a LIBOR transition event that the ARRC and other industry groups have recommended market participants include in their documentation. A LIBOR Discontinuance Event occurs upon the permanent cessation of the publication of the relevant LIBOR5 or upon the occurrence of an announcement by the regulator of the administrator of LIBOR that LIBOR is no longer representative.6 

Upon the transition to the Recommended Benchmark Replacement, “Benchmark Replacement Conforming Changes” to such Recommended Benchmark Replacement may be applied. Benchmark Replacement Conforming Changes include technical, administrative or operational changes reasonably necessary for the use, calculation or administration of the Benchmark Replacement. Such Benchmark Replacement Conforming Changes may either be (i) recommended by a Relevant Recommending Body, or (ii) determined by the “calculating person”7in its reasonable judgment. Clause (ii) only applies if the calculating person determines in its reasonable judgment that the Benchmark Conforming Changes recommended by a Relevant Recommending Body do not apply to or are insufficient for a particular contract, security or instrument. When Clause (ii) does apply, the Benchmark Replacement Conforming Changes shall include such changes, alterations or modifications that, in the reasonable judgment of the calculating person, (1) are necessary to permit administration and calculation of the Recommended Benchmark Replacement under or in respect of such contract, security or instrument in a manner consistent with market practice for substantially similar contracts, securities or instruments and, to the extent practicable, the manner in which such contract, security or instrument was administered immediately prior to the LIBOR replacement date, and (2) would not result in a disposition of such contract, security or instrument for US federal income tax purposes.

The New York LIBOR Legislation is also intended to serve as a safe harbor for the use or selection of the Recommended Benchmark Replacement. It provides that the recommended benchmark replacement is a commercially acceptable alternative and substantial equivalent to US dollar LIBOR, and that the selection of the Recommended Benchmark Replacement does not impair the rights or obligations of the parties, including with respect to the right to receive payment or to affect the timing or amount of payment. Under the New York LIBOR Legislation, replacement of US dollar LIBOR-based rate with a rate using the Recommended Benchmark Replacement does not (i) excuse or discharge performance of contractual obligations, (ii) allow for the termination or suspension of obligations, (iii) result in a breach of contract or (iv) render the contract voidable as a result of the discontinuance of US dollar LIBOR or the use of the Recommended Benchmark Replacement. 

Contracts, securities or instruments with provisions that would result in a non-LIBOR-based rate as the LIBOR fallback rate, e.g., the Fed Funds rate or Prime rate, are not affected by the New York LIBOR Legislation. In addition, the New York LIBOR Legislation permits parties to a contract, security or instrument to agree to a fallback rate other than the Recommended Benchmark Replacement rate so long as such alternative rate is not based on LIBOR. Finally, parties have a right to opt-out of the New York LIBOR Legislation. To the extent parties do opt-out or determine to use or select a rate other than the Recommended Benchmark Rate, the New York LIBOR Legislation provides that no negative inference shall be drawn. However, the express limitation from liability for damages or equitable relief provided by the New York LIBOR Legislation for selection of the Recommended Benchmark Replacement does not apply to the selection of another non-LIBOR-based alternative to such Recommended Benchmark Replacement rate.

A large number of difficult to amend contracts, securities or transactions that are governed by New York law and that have no fallbacks or LIBOR-based fallback language mature after the US dollar LIBOR cessation/non-representativeness dates of December 31, 2021, and June 30, 2023. For some of such contracts, securities or transactions, the New York LIBOR Legislation may provide relief, but not all types of contracts, securities and transactions will benefit from its transition provisions and safe harbor. For example, certain flow-through weighted average securitizations with underlying notes governed by the laws of the states where the relevant assets are located may not benefit from a New York solution to the extent they are governed by state laws that have not (yet) adopted a similar solution. Instead, a federal solution applicable in all 50 states and the District of Columbia will be necessary to provide similar relief for these types of securitizations.

The New York LIBOR Legislation additionally curtails many potential causes of action under New York law for contracts governed by New York law, but the LIBOR transition could still give rise to possible contractual and tortious claims under other states’ laws to the extent the transactions in question were governed by such other states’ laws. This may include other states’ ability to limit the application of the parties’ express choice of New York law to the extent the transactions involve the parties or activities in such other states.

Challenges relating to the enforceability of LIBOR-based obligations due to the inadequacy or misapplication of LIBOR fallbacks could arise under the laws of other states that have not adopted a solution akin to the New York LIBOR Legislation.8 Such challenges might include that the inadequacy or misapplication of a LIBOR fallback (i) made the performance of the contract, security or instruments impracticable, e.g., due to unforeseen events whose occurrence undermined the basic assumptions underlying the transaction, (ii) unforeseeably frustrated the intended purpose of the contract security or instrument, e.g., hedging of other LIBOR-based obligations or providing a well-known global unsecured bank lending rate, or (iii) breached the express obligation to provide a particular rate or the implied obligation of a party to act fairly and in good faith in exercising discretion to determine a replacement rate.

In addition, there could be claims made under federal law, to the extent federal laws apply. For example, with respect to securities transactions, claims could be made under federal securities law that assert inadequate disclosure was provided regarding the potential cessation of LIBOR and the inadequacy of fallbacks to deal with LIBOR’s cessation9 or, if the securities were subject to the Trust Indenture Act, that assert insufficient debt holder consent was obtained regarding the change to an interest rate not based on LIBOR. Additional claims might also be raised under other federal laws, including under antitrust or other laws, challenging the methodology used in connection with developing a market-based fallback rate to LIBOR. 

It should also be noted that the New York LIBOR Legislation may also be subject to claims under the above-mentioned federal laws and, in addition, subject to challenges based on the United States Constitution, in particular with respect to the “Contracts Clause” (Article I, Section 10, Clause 1) and the “Takings Clause” (Amendment V). The Contracts Clause provides that no state shall pass any law impairing the obligation of contracts. The Contracts Clause has been interpreted by some courts as being an absolute prohibition. An analysis of whether the New York LIBOR Legislation violates the Contracts Clause would require an inquiry that includes, among other things, a determination of whether the impairment is substantial and/or reasonable and necessary to serve a legitimate public purpose. The Takings Clause provides that private property shall not be taken for public use without just compensation. Like the Contracts Clause, courts have looked to various questions to be addressed in determining the application of the Takings Clause, including whether or not particular contract rights constitute property interests for purposes of the Takings Clause and, to the extent it is deemed a regulatory taking, the degree of impact on the value of right or property and the parties’ reasonable expectations.

II. US Congress/Federal Legislation

Because of the potential challenges that could be raised under federal law and under the laws of the various states, including those that are discussed above, a “federal solution” in addition to the “New York solution” afforded by the New York LIBOR Legislation has been suggested as necessary to ensure an orderly transition away from LIBOR and to limit unnecessary litigation.

The United States Congress began working on a draft version of federal legislation in October of 2020 that would provide a statutory substitute benchmark rate for contracts that use LIBOR as a benchmark and do not have any fallback clauses other than LIBOR. When LIBOR is no longer available, the proposed law would convert the interest rate in these contracts to a new replacement benchmark chosen or recommended by the Federal Reserve Board of Governors of the Federal Reserve Bank of New York or the ARRC.

While similar to the New York LIBOR Legislation, there are differences in the current draft of the federal legislation, which was discussed on April 15, 2021, in the Subcommittee on Investor Protection, Entrepreneurship and Capital Markets. These include, perhaps most significantly, that the draft bill specifically provides for the preemption of state law, which would include the New York LIBOR Legislation. In addition, based on statements made by members of Congress at that hearing, though a consensus appears to exist regarding the need for federal legislation to address the LIBOR transition, there are aspects of the proposed draft law, including its inclusion of the recommended benchmark replacement rate based on SOFR supported by the Federal Reserve and the ARRC and included in the New York LIBOR Legislation, that are under further consideration.

III. The time to prepare for the transition away from LIBOR should no longer be delayed

To the extent some market participants have been awaiting the passage of the New York LIBOR Legislation before fully engaging in evaluating and transitioning their LIBOR-based securities, loans, investments, contracts and other instruments, the time to move forward with such plans is now. Notwithstanding that the New York LIBOR Legislation and, potentially, similar federal legislation will likely assist a company or firm in implementing an efficient LIBOR transition plan, the laws by themselves may not fully address their exposure to the LIBOR transition to the extent they do not apply to certain transactions; could affect the manner in which certain transactions will be transitioned; or, as noted above, are successfully challenged and deemed unenforceable. Furthermore, since the New York LIBOR Legislation only applies to US dollar LIBOR, parties to multicurrency or non-US dollar LIBOR transactions that do not have suitable LIBOR fallbacks will need to obtain further clarification on how the LIBOR cessation will impact their contracts.

Delay is no longer an option.10 LIBOR transition plans take time to develop and implement since many aspects of a company’s or a firm’s business may be affected by the discontinuation of LIBOR. In addition to amending legal documents to provide one or more fallbacks to alternative reference rates, market participants should determine and, to the extent possible, minimize the financial, operational, regulatory, technology, client outreach and other risks that the discontinuation of LIBOR could have on their policy, goods, processes, models and information systems. In addition to identifying which of its securities, contracts and other instruments are exposed as a result of the LIBOR transition, a company’s or firm’s LIBOR transition plan should include: (1) a plan for contract remediation, (2) client strategy for LIBOR-related communications, (3) risk and valuation models, (4) impact assessment methods, and (5) a transition plan for the new benchmark markets and products. Since each company or firm may offer product offerings and portfolios which vary (based on each unique business and hedging strategies and customer priorities), each company or firm’s LIBOR transition plan may be distinctly diverse.

While it may be difficult to predict the effect of the end of LIBOR on a business, this should not delay in evaluating a company’s LIBOR exposure, risk management and disclosure efforts.

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