Proposed Benchmark Replacements

The Federal Reserve has proposed critical rules to implement the Federal LIBOR transition legislation – the Adjustable Interest Rate (LIBOR) Act.  

These rules enumerate the particular Board-selected benchmark replacements which, if utilized, would (i) become effective by operation of law on the USD LIBOR end date (currently June 30, 2023) and (ii) foreclose any claim or cause of action at law or in equity including, but not limited to, liability for damages due to the transition:

Analysis

Rate Mismatches

SOFR, like 30-Day Average SOFR, is a preferred replacement since it is an actual interest rate and, thus, is less susceptible to manipulation as it is based on actual Treasury transactions (as compared to market estimates). However, the dilemma for most commercial borrowers is that their commercial loans utilize Term SOFR rather than the ISDA-established benchmark for derivatives – SOFR.

This could easily lead to a mismatch in rates for hedged transactions meant to reduce variable rate risk, reducing the benefits for borrowers, as well as banks. This is especially important in today’s increasing interest rate environment. 

Transition Smoothing for Consumer but not Commercial Facilities

Term SOFR is a derivative (and not an actual) rate which experienced market dislocations in January 2022 as USD LIBOR transition implementation commenced in earnest. These dislocations are expected to be markedly worse on or about June 30, 2023.  

As a result, the Federal Reserve appropriately proposed a 1-year averaging period for post-LIBOR benchmark replacement interest rates for consumer loans but did not propose the same transition averaging for commercial transactions.

‘Zombie’ Appearances

There has been evidence of a number of Zombie apparitions during the LIBOR transition: (i) ARRC formed in 2014 and reconstituted in 2018, (ii) USD LIBOR transition implementation deadlines in 2015, 2021, and now, 2023, (iii) USD LIBOR benchmark replacements in 2017, 2021 and 2022, and (iv) the aforementioned use of synthetic rates for Yen LIBOR and Pound LIBOR.

The commentary with the Federal Reserve rules insists that a LIBOR-based contract with a clear and practicable benchmark would be the rate post-transition, even if synthetic (i.e., Zombie) LIBOR continues to be published on and after the LIBOR replacement date. The Federal Reserve’s proposed rules are just that, proposed and have not been finalized. Based upon the Federal Adjustable Interest Rate (LIBOR) Act, these rules were required to be finalized by the Federal Reserve in September.

The Mystery

Therefore it is not clear what the Board-selected benchmark replacements are yet under the LIBOR Act and when the final rules will be promulgated. How, then, can banks and borrowers be entering into LIBOR transition documentation without a clear and practicable Board-selected benchmark in place?

Needless to say, watch out for Zombies and HAPPY HALLOWEEN!

FOOTNOTES

^[1] _{See the Client Alert entitled ‘As Halloween Approaches, ‘Zombie’ LIBOR is Scheduled to Appear,’ dated October 4, 2021.}

^[2] _{ARRC December 12, 2014 meeting minutes, citing the initial Working Group on Alternative Reference Rates Terms of Reference, dated November 13, 2014.}

^[3] _{See the Client Alerts entitled (i) ‘The End of LIBOR: The Twilight Zone™ Edition,’ dated March 11, 2021, and (ii) ‘ISDA 2020 IBOR Fallbacks Protocol,’ dated October 26, 2020.} 

^[4] _{See the Client Alert entitled ‘Federal Law to the Rescue? (The Senate Version)’ dated April 14, 2022.} 

^[5] _{Government-Sponsored Enterprises (GSEs) include Fannie Mae, Freddie Mac, and the Federal Home Loan Banks, and contracts include (i) commercial, and multifamily mortgage loans, (ii) commercial and mortgage-backed securities (MBS), (iii) collateralized mortgage obligations (CMOs), (iv) credit risk transfers and (v) Federal Home Loan Bank advances.}

^[6] _{Our preferred benchmark replacement for most facilities.}