New York’s LIBOR Replacement Law: A Useful Step That Leaves Lingering Questions For ‘Tough Legacy’ Contracts – Finance and Banking

Bizar Male

Introduction

Since the Financial Stability Board issued its report
recommending reforms to interest rate benchmarks (including the
London Interbank Offered Rate (LIBOR) in 2014),1 market
participants have devoted considerable resources to prepare for
LIBOR’s eventual cessation. The Federal Reserve Board and the
New York Fed convened private industry participants to form the
Alternative Reference Rates Committee (ARRC), a group that has been
tasked with weaning U.S. markets off LIBOR after 2021. Based on
model language formulated by ARRC, in April 2021, the New York
State Legislature adopted new Section 18-C of the General
Obligations Law, which provides a fallback following cessation of
LIBOR for contracts governed by New York law that utilize LIBOR but
lack a replacement benchmark. The new statute is a useful step, but
there are questions as to its coverage, implementation and
enforceability.

Background

As recently summarized by the Financial Conduct Authority (FCA)
of the United Kingdom, “the lack of an active underlying
market makes LIBOR unsustainable, and unsuitable for the widespread
reliance that had been placed upon it.”2 In July 2017, the FCA
announced that it intended to stop persuading or compelling banks
to submit rates for the calibration of LIBOR to the administrator
of LIBOR after 2021.3 In March of this year, the FCA
confirmed that all LIBOR settings currently published by ICE
Benchmark Administration (IBA) will either cease to be provided by
any administrator or no longer be representative:

  • immediately after December 31, 2021, in the case of all
    sterling, euro, Swiss franc and Japanese yen settings, and the
    one-week and two-month U.S. dollar settings; and

  • immediately after June 30, 2023, in the case of the remaining
    U.S. dollar settings.

The recent announcement by the FCA has increased the pressure on
market participants that have relied on LIBOR to complete
transition plans by the end of 2021.4

In the United States, ARRC has played a critical role in
organizing and supervising the transition away from LIBOR,
providing guidance on best practices and proposing legislation
providing for an automatic benchmark replacement rate. Among other
things, ARRC has proposed the Secured Overnight Financing Rate
(SOFR),5 published by the Federal Reserve Bank of
New York, as an alternative to LIBOR for use in contracts that are
currently indexed to U.S. dollar LIBOR, and has proposed a paced
market transition plan to SOFR.

Any type of contract, security or instrument whose terms include
rates based on or derived from LIBOR will be affected by the
impending transition away from LIBOR-based rates. Certain
instruments, however, provide less challenges than others. For
example, the difficulty of the transition away from LIBOR for
derivatives contracts has been more or less blunted by the ISDA
IBOR Protocol.6 Commercial loans and credit facilities,
which involve a relatively small number of lenders and are actively
administered by an agent, are more readily amended, and many such
facilities have already been modified to introduce a fallback
mechanism. Even absent any amendment, these types of facilities
typically allow borrowers to select from a list of alternative
interest rate benchmarks, so that the facilities can continue to
function even if LIBOR is unavailable. On the other hand, bonds and
securitizations are often widely held and are difficult to amend,
particularly with respect to interest rates. Instruments of this
type, whose interest rates are LIBOR based but whose issuance
predates the conversation on a transition away from LIBOR, present
particularly vexing issues and have been referred to by the FCA as
the “tough legacy” contracts.

In April 2021, the New York Legislature passed legislation,
based on a model formulated by ARRC,7 to provide a fallback
following the cessation of LIBOR for financial instruments governed
by New York law that employ LIBOR but lack a replacement mechanism.
The statute, which is codified as new Article 18-C of the New York
General Obligations Law (GOL), is intended in particular to address
the conundrum of the tough legacy contracts. Whether it does so
successfully, however, is subject to question, as the statute
itself seems to acknowledge.

A Summary of the New York Statute

The new statute is found in four sections, 18-400 to 18-403, of
the NY GOL.

  • Section 18-400 is comprised of 14 definitions, some of which
    have subsections and subclauses, that are utilized in the
    statute.

It is useful to cite a few defined terms at the outset.

“Benchmark” refers to “an index of interest
rates or dividends rates that is used, in whole or in part, as the
basis of or as a reference for calculating or determining any
valuation, payment or other measurement under or in respect of a
contract, security or instrument.” LIBOR of course is such a
benchmark and is the focus of the statute.

“Benchmark replacement” means a benchmark
“(which may or may not be based in whole or in part on a
prior setting of LIBOR), to replace LIBOR or any interest rate or
dividend rate based on LIBOR . . . .”

“Fallback provisions” mean “terms in a
contract, security or instrument that set forth a methodology or
procedure for determining a benchmark replacement . . .
.”

  • Section 18-401 legislates the effects of the discontinuance of
    LIBOR on covered agreements.

  • Section 18-402, titled “Continuity of contract and safe
    harbor,” is a legislative proclamation as to the
    reasonableness the statute’s LIBOR replacement mechanism and
    an exculpation of liability for reliance on the statute. As
    discussed below, it appears intended to deflect certain challenges
    to the statute.

  • Section 18-403 provides for severability of the statute, such
    that if the application of any of its provisions are deemed to be
    invalid to any person or circumstance, the invalidity does not
    affect the statute’s other provisions. This unusual statement
    is almost an acknowledgment that application of the statute may be
    legally infirm when applied to certain contracts, as addressed
    below.

Coverage

The New York statute applies to contracts, securities and
instruments whose terms:

  • include interest rates or dividend rates determined by
    reference to U.S. dollar LIBOR; but

  • do not contain a fallback provision or contain a fallback
    provision essentially relying on Libor.

Importantly, if a contract has its own LIBOR replacement
mechanism, the statute will not apply.

Benchmark replacement

The key operative provision of the New York statute states that
– 

“On the LIBOR replacement date, the recommended benchmark
replacement shall, by operation of law, be the benchmark
replacement for any contract, security or instrument covered by the
statute.”

The LIBOR replacement date is defined as either
– 

  • the later of (i) the date of a public statement on behalf of
    the administrator of LIBOR or by certain other persons that the
    administrator of LIBOR has ceased or will cease to provide LIBOR
    and (ii) the date on which the administrator of LIBOR ceases to
    provide LIBOR; or

  • a public statement by the regulatory supervisor for the
    administrator of LIBOR that LIBOR is no longer representative.

These events are referred to as “LIBOR discontinuance
events.”8

Recommended benchmark replacement is defined as a benchmark
replacement based on SOFR, and includes any spread adjustments and
conforming changes selected or recommended by the Federal Reserve
Bank, the Federal Reserve Bank of New York or ARRC.9

The statute also authorizes a “calculating person”
to make other changes, alternations or modifications that in its
reasonable judgment are necessary to permit the administration and
calculation of the recommended benchmark replacement. Calculating
person is defined with respect to a contract, security or
instrument as a person “responsible for calculating or
determining any valuation, payment or other measurement based on a
benchmark.” This should include a calculation or similar
agent under an indenture or other debt instrument — often the
same person as the trustee — and gives this agent the
authority to tailor the SOFR-based LIBOR replacement to the
particular contract, security or instrument.

An alternative benchmark selected by a “determining
person”

If there exists a “determining person” with respect
to a contract, security or instrument, the statute permits the
determining person to select a different LIBOR replacement in lieu
of the SOFR-based recommended benchmark replacement. A determining
person may select a LIBOR replacement at any time, without waiting
for the LIBOR replacement date.

A determining person is defined as, among other things, a person
with the “authority, right or obligation” to
“calculate or determine a valuation, payment or other
measurement based on a benchmark.” The definition is similar
in this regard to the definition of calculating person, but is
distinct in the discretion given to determining persons to select a
replacement rate. Should it choose to exercise its authority under
the statute, a determining person (should one exist under an
indenture) would be empowered to choose an alternative to a
SOFR-based rate as a replacement for LIBOR.

Some Observations

Sacred rights

The New York statute is sensitive to the customary indenture
provisions, typically referred to as being among the “sacred
rights” of noteholders, which require unanimity to modify the
interest rate under the indenture. For indentures qualified in the
Trust Indenture Act of 1939 (TIA), section 316(b) of the TIA
similarly provides that the right of a holder of an indenture
security to receive a payment of principal and interest on the
respective due dates expressed in the indenture cannot be impaired.
Seemingly in order to blunt the effect of such provisions, the
statute provides that the selection and/or implementation of a
recommended benchmark replacement shall not constitute an amendment
or modification of any contract, and shall be deemed to not
“prejudice, impair or affect any person’s rights,
interests or obligations under or in respect of any
contract.”

It remains to be seen whether legal objections to the statute
will be lodged based upon the sacred rights of noteholders or the
TIA, and if raised, how they will be dealt with in the courts. On
the one hand, a New York statute purporting to override a provision
of a previously executed indenture or the TIA, which is a federal
statute, seems problematic. On the other hand, without
modification, the indenture will be unworkable by its terms after
the cessation of LIBOR.

What is meant by “based on SOFR”?

As noted above, the default replacement rate under the statute
is a “benchmark replacement based on SOFR.” By its
terms, the statute does not prescribe a specific substitute for a
LIBOR-based interest rate formula. Rather it mandates that a
replacement should be based on SOFR. The Federal Reserve
publishes a variety of SOFR-based quantities. These include 30-,
90- and 180-day SOFR averages, and a SOFR index that can be used to
calculate averages over custom periods of time.10 In
contrast to LIBOR, which is a forward-looking rate benchmark,
however, these averages are based on historical rates. ARRC is
considering formulation of a forward-looking SOFR-based rate,
referred to as Term SOFR, but has said that it is not currently in
a position to recommend such a rate.11

Presumably, a SOFR-based benchmark replacement should be one
that most closely approximates the tenor of the LIBOR quantity that
it is intended to replace, even if the match is imperfect.12 For
example, a 90-day SOFR average might be used as a replacement for
an interest rate based on three-month LIBOR. But simply porting
over a corresponding SOFR quantity will be insufficient, and a
number of adjustments may be necessary. The need for such
adjustments is recognized by the New York statute, which includes
in the “recommended benchmark replacement,” applicable
by default, spread adjustments and conforming changes that may be
promulgated by the Federal Reserve Bank, the Federal Reserve Bank
of New York or ARRC. For example, ARRC is recommending a spread
adjustment for translating between LIBOR and SOFR, using a
methodology based on a historical median of the difference between
the two quantities over a five-year lookback period.13

Exercise of agent discretion

By authorizing calculating persons and determining persons to
exercise discretion on the discontinuation of LIBOR, the New York
statute provides for necessary flexibility in implementing a
replacement benchmark in tough legacy contracts such as indentures.
Discretion, however, is not something that a trustee or similar
agent is wont to exercise in the absence of an event of default. A
trustee by inaction can default to a SOFR-based LIBOR substitute,
as prescribed by the statute. But even with a SOFR as the
replacement, there will, as noted, be a need to translate to a
particular SOFR-based quantity. There may also be a need for
conforming modifications to an instrument that cannot be prescribed
on a “one size fits all” basis by ARRC or the Fed, and
that will require drafting tailored to a particular instrument.

Indenture trustees functioning as calculation agents will need
to consider whether to make such modifications on their own, in
conjunction with the issuer or with some form of noteholder
support, even if this can only be obtained from less than all
noteholders. Trustees will also have to decide on the form these
modifications will take. Typically, indentures and like instruments
are modified through a supplemental indenture, and a trustee is not
required to enter into a supplemental indenture without an opinion
of counsel. An unqualified legal opinion may be difficult to obtain
where there is a modification of sacred rights, however. Trustees
and their counsel will need to consider whether a reasoned opinion
— one that is based on an analysis of the law and facts
— will suffice in these unique circumstances.

Problems with fallback provisions

As noted, the New York statute does not apply to a contract,
security or instrument that contains fallback provisions for
determining a benchmark to replace LIBOR. The exclusion seemingly
would apply even in circumstances in which as a practical matter it
would be exceedingly difficult to implement the replacement
benchmark. For example, the agreement governing a security might
require a very high level of consent by holders — one that is
unlikely to be achieved — in order to switch to an
alternative benchmark. This could very well create a gap in the
coverage of the statute.

Certain tax considerations14

The adoption of a replacement rate, whether by agreement of the
parties to the contract or by operation of law as set forth in the
New York statute, raises several income tax considerations. Perhaps
most significantly, if such adoption were to give rise to a
“significant modification” of a debt instrument, (i) it
could cause holders to recognize gain or loss with respect to the
debt instrument and (ii) if the debt instrument is trading at a
discount at the time the replacement rate is adopted, it could
cause holders to accrue original issue discount going forward and
issuers to recognize cancellation of indebtedness income.

In October 2019, the Treasury Department and the Internal
Revenue Service issued proposed regulations to address the federal
income tax consequences of the transition away from LIBOR and other
interbank offered rates (IBOR). In brief, Proposed Treasury
Regulation Section 1.1001‑6 generally provides that if the
terms of a debt instrument or non-debt contract are altered or
modified to replace, or provide or alter a fallback to, an
IBOR-referencing rate with a “qualified rate,” such
alteration or modification (and any “associated”
alterations or modifications, such as the addition of an obligation
for a party to make a one-time payment to offset the change in
value of a debt instrument resulting from replacement of the
IBOR-referencing rate) will not result in recognition of income,
gain, deduction or loss to any party thereto under Section 1001 of
the Internal Revenue Code.

A qualified rate generally includes, but is not limited to, a
rate based on SOFR, provided the fair market value of the debt
instrument or non-debt contract after the alteration or
modification is substantially equivalent to its fair market value
prior thereto. In determining fair market value for this purpose,
the parties may use any reasonable, consistently applied method,
taking into account the value of any one-time payment as described
above.

Governing law

The New York statute only addresses contracts, securities and
instruments governed by New York law. Although by convention New
York law governs a substantial majority of indentures and credit
facilities, if a financial agreement or instrument were governed by
the law of another jurisdiction, the New York statute would be
unavailing. Congress has begun consideration of federal legislation
that would address the transition away from LIBOR, and which would
apply irrespective of the governing law of an agreement or
instrument or where the parties may be located.15 Also,
unlike a state statute that might be attacked for inconsistency
with the TIA’s provision on individual entitlement to payment
of interest, a federal statute can simply override the TIA in this
regard.

When to act

Finally, there is a question of timing. According to the FCA,
U.S. LIBOR will not be discontinued until June 2023, giving parties
responsible for tough legacy contracts such as indentures time to
decide upon a course of action. It would appear advisable, however,
not to wait until the actual discontinuation of LIBOR to take
action on the transition. Documentation will likely need to be
drafted to implement the transition, and various constituencies may
need to be consulted, even as the New York statute provides the
framework and legal underpinning for the required modifications.
The time to act is relatively
soon.      

Conclusion

New Article 18-C of the New York General Obligation Law is the
attempt of the New York Legislature to address by legislative fiat
the serious problem of legacy financial instruments that employ
LIBOR as a basis for their interest or dividend determinations, but
have no provision for dealing with the termination of LIBOR in June
2023. The issue is particularly acute with respect to indentures
and similar instruments that govern widely held securities
requiring unanimity to alter their interest rate provisions. As the
statute itself seems to recognize, it is not at all certain that it
is possible to repair these securities through legislative action.
The alternative, however, is either contractual paralysis or
judicial intervention, so it is hoped that the legislative solution
will hold. In all events, issuers and their trustees or other
agents under these tough legacy contracts should begin to engage on
these instruments, utilizing the framework provided by Article 18-C
to address the transitional and drafting issues that are bound to
arise.

Footnotes

1 See https://www.fsb.org/wp-content/uploads/r_140722.pdf.

2 See
https://www.fca.org.uk/news/press-releases/announcements-end-libor
.  

3 See https://www.fca.org.uk/news/speeches/the-future-of-libor.

4 The recently
enacted Financial Services Act of 2021 in the U.K. (see https://bills.parliament.uk/bills/2792#timeline)
allows the FCA to prohibit use of benchmark rates whose prospective
cessation has already been confirmed by regulators, even if the
cessation date has not been confirmed. Any supervised entity whose
contracts continue to rely on any such prohibited benchmark rate,
even if still technically available and in use, would be in
violation of applicable regulations. This could be of particular
concern for  subsidiaries of U.S. banks and investment firms
based in the U.K.

5 See, e.g., https://www.newyorkfed.org/markets/reference-rates/sofr

6 See
ISDA IBOR Protocol page, available at
https://www.isda.org/protocol/isda-2020-ibor-fallbacks-protocol/,
allowing all adhering parties to have their master agreements in
respect of derivatives and other financial transactions deemed
amended to provide for fallback rates upon certain defined
triggering events and, in some cases, interpolation of discontinued
rates. See our firm memo “IBOR Transition: What’s the
Protocol for Derivatives?” 
https://www.kramerlevin.com/en/perspectives-search/isda-publishes-2020-ibor-fallbacks-protocol.html

7 See
https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2021/20210324-arrc-press-release-passage-of-libor-legislation

8 The
corresponding terms under the ISDA Protocol are “Index
Cessation Event” and “Index Cessation Effective
Date.” They are similarly defined, although there are certain
differences.

9 In addition,
Section 18-401(2) provides that “any fallback provisions in a
contract, security, or instrument that provide for a benchmark
replacement based on or otherwise involving a poll, survey or
inquiries for quotes or information concerning interbank lending
rates or any interest rate or dividend rate based on LIBOR shall be
disregarded.” Often, a LIBOR-based loan or instrument will
include a provision for “polling” a specified number of
financial institutions for their LIBOR rates if the LIBOR benchmark
rates that are utilized are not being published. The statute
appears to eliminate such polling provisions, to the extent they
would apply to a replacement for LIBOR. The reference to fallback
provisions, however, renders application of this provision somewhat
uncertain.

10 See

https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2021/20210511-guide-to-published-sofr-averages
.

11 See
https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2021/arrc-press-release-term-rate-for-publication
.

12 See
id. “The ARRC urges market participants not to wait for a
forward-looking term rate for new contracts, but to instead be
prepared to use the tools available now, such as SOFR averages and
index data . . . .”

13 See

https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2020/ARRC_Recommendation_Spread_Adjustments_Cash_Products_Press_Release.pdf
.

14 For a more
detailed discussion of the tax considerations, see our firm memo
“Proposed Regulations Mitigate Tax Issues Lurking in
LIBOR-Referencing Debt Instruments and Other Contracts,”
available at 
https://www.kramerlevin.com/en/perspectives-search/proposed-regulations-mitigate-tax-issues-lurking-in-libor-referencing-debt-instruments-and-other-contracts.html
.

15 See

https://financialservices.house.gov/calendar/eventsingle.aspx?EventID=407534
.

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.

Next Post

Hong Kong amends electoral law, limits public vote

Hong Kong’s legislature on Thursday passed a bill amending the electoral laws to limit public voting rights, The Associated Press reported. The bill will allow pro-Beijing lawmakers to make decisions for the city and lets the city’s security department run background checks on possible candidates.  The bill also gives the pro-Beijing election committee 40 new seats in […]