On March 15, 2022, President Biden signed the Adjustable Interest Rate (LIBOR) Act (the LIBOR Act). The long-awaited federal law addresses the disruption of contractual continuity and litigation risk posed by financial instruments that incorporated U.S. dollar LIBOR for interest payments, but lacked a fallback solution to replace the benchmark in the event of termination.
These contracts will now be amended to replace the LIBOR benchmarks with a rate based on the Secured Overnight Financing Rate (SOFR). Unless a person eligible for the contract has designated another standard for the contract or if it has been modified by the parties.
The federal law – part of the Consolidated Appropriations Act 2022 – fills a void that until recently had only been partially filled by state laws aimed at addressing the same issue and will reduce the risk of default and dispute. The law directs the Federal Reserve Board of Governors to issue regulations to complete its mandate within 180 days.
LIBOR (acronym for London Interbank Offered Rate) is the benchmark interest rate for a large number of financial contracts, including cash, loans, debt securities and derivative transactions. This is an interest rate calculated from data from various banks active in the London financial markets and represents a rate at which these banks are willing to lend to each other.
Long the main global benchmark for interest rates, LIBOR was phased out on December 31, 2021 in almost all currencies and maturities, following a series of market manipulation scandals. And while regulators have granted a temporary reprieve to US dollar LIBOR on several occasions, this is also set to end after June 30, 2023. The transition from LIBOR to risk-free rates such as SOFR for the US dollar and the Sterling Overnight Interbank Average for the pound was largely successful.
However, legislators and regulators are concerned about the risks of litigation and breach of contractual continuity. Many legacy contracts and financial instruments incorporate LIBOR but lack provisions to replace the benchmark with a different rate. Some contain no fallback if LIBOR is removed, while others contain impractical fallbacks, such as a provision for a LIBOR-style survey of benchmark banks for their cost of funds.
Meanwhile, others contain securities that could significantly alter the economics of a transaction, such as reverting to the last available LIBOR screen rate or the last published LIBOR. Although many old contracts without practical alternatives have been or can still be changed through negotiation between the parties, this is not always possible.
The existence of old contracts after LIBOR expires creates the risk of litigation and market disruption. The parties to these contracts may terminate them on the basis of arguments such as non-performance, force majeure, impossibility or impossibility of performance. This could leave counterparties uncertain as to whether they are subject to binding obligations and, if so, under what conditions. Of course, such litigation would entail significant expense for all parties. Although the extension of the US dollar LIBOR deadline in the most frequently used maturities until after June 30, 2023 reduces the magnitude of the problem, significant risks remain.
To mitigate these risks, several jurisdictions have adopted regulatory fixes. For example, in April 2021, the New York Legislature amended the General Government Obligations Act specifically to address the end of US dollar LIBOR. LIBOR is similar to New York law, although the latter law only affects New York legal instruments.
What will LIBOR change?
From the relevant LIBOR replacement date (the first London banking day after 30 June 2023 for LIBOR in most maturities), the LIBOR law automatically invalidates fallback contractual provisions which are:
- based on US dollar LIBOR; Where
- involve polls, surveys and surveys.
Where a provision has been invalidated, or where a contract subject to the law contained no fallback provision, SOFR plus a spread adjustment (reflecting the lower interest rate of overnight standards such as SOFR per compared to LIBOR) automatically becomes the fallback solution. This is unless a relevant person under the contract, such as a trustee or calculation agent, has already designated another benchmark for the contract or it has been changed by the parties.
When LIBOR is superseded by the recommended benchmark, federal law now declares a rate based on SOFR as a “commercially reasonable replacement and commercially substantial equivalent to LIBOR.” These provisions go a long way to guarantee the continuity of the contract.
The law also expressly creates a safe harbor against litigation. If a determining person changes LIBOR to a rate based on SOFR in the circumstances specified in the statute, such action shall not be “deemed to impair or affect the right of any person to receive payment, or affect the amount or timing of this payment. payment, under any LIBOR contract”. Accordingly, a Determined Person shall not be subject to any claim or cause of action arising out of the selection or use of such substitute.
In addition, the selection of a Board-Chosen Reference Alternate must not:
- release or excuse for performance of the contract “for any cause, claim or defence”;
- justify the termination or suspension of a party’s performance;
- constitute a breach of contract; Where
- rescind or rescind any LIBOR contract.
Because the federal law supersedes previously enacted state laws to address the termination of LIBOR, it will provide consistent standards across the United States. This will lead to greater certainty in the market and reduce the risk of litigation.
This article first appeared on our blog Banking Litigation Notes
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