Background

Since the winter of 2020, we have published three articles on the phaseout of LIBOR, most recently in 2021, advising our business clients of major developments regarding LIBOR. “LIBOR” (the acronym for the London Interbank Offered Rate) was an interest-rate average calculated from estimates submitted daily at noon to the British Bankers’ Authority. It had served since the 1980s as a premier benchmark for short-term (overnight to one year) interest rates around the world. For decades, lenders have extended credit facilities using LIBOR-based interest rates and loan documents such as adjustable mortgages and promissory notes. In addition, bonds and nonfinancial corporate often contain LIBOR-related provisions. More specifically, LIBOR served as the benchmark rate in more than $200 trillion worth of contracts worldwide, including approximately $5 trillion in consumer loans.

LIBOR’s administrator calculated and published LIBOR each London business day for five currencies and seven borrowing periods, known as tenors (overnight, one week, one month, two months, three months, six months, and twelve months).

After the global financial crisis in 2008, the number of LIBOR-based transactions decreased. Significantly, at the time authorities in the United States and the United Kingdom discovered traders had manipulated the benchmark for personal profit. Major banks were fined billions of dollars, and traders were convicted and sentenced to jail time. The administration of LIBOR was transferred to a new administrator, ICE (Intercontinental Exchange) Benchmark Administration Limited (IBA), an entity regulated by the U.K.’s Financial Conduct Authority (FCA).  But despite increased regulatory oversight and efforts made to improve LIBOR, confidence in it continued to diminish, and financial regulators and market participants began to search for alternative reference rates and to develop plans for a transition away from LIBOR.

In 2014, the Federal Reserve Board (the Board) and the Federal Reserve Bank of New York (the specified member of the Federal Reserve System that oversees international money transactions) formed the Alternative Reference Rates Committee (ARRC) to lead the transition from USD LIBOR. The ARRC is also actively engaged in efforts led by the International Swaps and Derivatives Association (ISDA) to develop a benchmark interest rate to replace USD LIBOR for USD LIBOR-denominated loans and securities. In 2017, the ARRC selected the Secured Overnight Financing Rate (SOFR) as the appropriate replacement index, and the New York Fed began publishing SOFR in April 2018. SOFR is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities, but it is indicative of market conditions and capital costs only when there are enough overnight transactions. LIBOR is predictive of costs and interest rates on a going-forward basis, whereas SOFR looks backward at transactions.

In response to the planned cessation of USD LIBOR, U.S. financial regulators encouraged market participants to transition away from USD LIBOR as a reference rate as soon as practicable. For example, in November 2020, the Office of the Comptroller of the Currency (OCC), the Board, and the Federal Deposit Insurance Corporation (FDIC) issued an interagency statement stating that banking organizations generally should not enter new contracts referencing USD LIBOR after Dec. 31, 2021. The ARRC and other private industry groups also have worked to encourage an orderly transition from USD LIBOR. For example, the International Swaps and Derivatives Association (ISDA) has developed a contractual protocol by which parties to derivative transactions governed by ISDA documentation and other financial contracts can agree to incorporate more robust contractual fallback provisions that replace references to LIBOR with an alternative benchmark based on SOFR.

On Dec. 31, 2021, the publication of LIBOR ceased as scheduled. To allow existing USD LIBOR contracts to mature without disruption, however, the FCA announced that the panels for the remaining five tenors of USD LIBOR would continue through, but cease after, June 30, 2023.

As a result of the efforts of the OCC, FDIC, the ARRC, and others, coupled with the cessation of publishing LIBOR, market participants extending credit facilities in 2022 have transitioned from LIBOR primarily to SOFR. There remain, however, a substantial number of LIBOR-based credit facilities that pre-date Dec. 31, 2021.

A key consideration for lenders is the ARR to be selected. Simply replacing LIBOR with SOFR in all credit facilities may not be the best choice. Other ARRs to be considered are (1) Term SOFR, which is indicative of the forward-looking measurement of overnight SOFR based on market expectations that are implied from derivatives markets, (2) the American Interbank Offered Rate (Ameribor), and (3) the Bloomberg Short Term Bank Yield Index (BSBY). The latter two are “credit-sensitive rates” calculated using a proprietary formula and include a means of capturing bank credit spreads. They have not, however, been formally recommended by the ARRC.

Adjustable Interest Rate (LIBOR) Act

Despite efforts to encourage market participants to prepare for the cessation of USD LIBOR, some have resisted. Resistance has come primarily from parties to “tough legacy contracts,” i.e., existing contracts that reference USD LIBOR; that will not mature by June 30, 2023; and that cannot be easily amended. These contracts typically lack adequate fallback provisions presenting a replacement benchmark to use after the cessation of USD LIBOR. To address these tough legacy contracts, several states adopted legislation to provide a remedy for financial contracts that reference USD LIBOR and have no effective means to replace it. While these state laws provided a solution for a substantial number of tough legacy contracts, further legislative action is needed to address such contracts governed by the laws of other states.

In response to the need for a uniform, nationwide solution for replacing references to USD LIBOR in tough legacy contracts, Congress enacted the Adjustable Interest Rate (LIBOR) Act (the LIBOR Act) in March 2022 as part of the Consolidated Appropriations Act. The Act lays out a set of default rules that apply to tough legacy contracts. Section 104, the main operative provision of the LIBOR Act, distinguishes three categories of LIBOR contracts with different types of fallback provisions. The LIBOR Act defines a “LIBOR contract” to include any obligation or asset that, by its terms, uses the overnight, one-month, three-month, six-month, or twelve-month tenors of USD LIBOR as a benchmark. The LIBOR Act defines “fallback provisions” as terms in a LIBOR contract for determining a benchmark replacement – that is, an alternative reference rate (ARR) including any terms relating to the date on which the ARR becomes effective.

The first category of LIBOR contracts comprises contracts that contain fallback provisions identifying an ARR that is not based in any way on any of the LIBOR Act’s USD LIBOR values and that do not require any person to conduct a poll, survey, or inquiries for quotes or information concerning interbank lending or deposit rates. These contracts are expected to transition to the contractually agreed-upon ARR provided by their fallback provisions on or before the LIBOR replacement date, i.e., the first London banking day after June 30, 2023.

The second category comprises contracts that contain no fallback provisions, as well as LIBOR contracts with fallback provisions that do not identify a determining person and that only (i) identify an ARR that is based in any way on any of the LIBOR Act’s USD LIBOR values or (ii) require that a person conduct a poll, survey, or inquiries for quotes or information concerning interbank lending or deposit rates. For these contracts, the LIBOR Act provides that the ARR on the LIBOR replacement date will be the Board-selected ARR, i.e., an ARR identified by the Board that is based on SOFR, including any tenor spread adjustments required under the LIBOR Act. Thus, any references to USD LIBOR in LIBOR contracts that fall into this second category will, by operation of law, be replaced by the Board-selected ARR on the LIBOR replacement date.

The third category encompasses LIBOR contracts that contain fallback provisions authorizing a specific person to determine an ARR. The application of the LIBOR Act to LIBOR contracts in this third category depends on the determination, if any, made by it. The LIBOR Act defines a “determining person” as any person that, with respect to any LIBOR contract, has the authority, right, or obligation, including on a temporary basis, as identified by the provisions of the LIBOR contract, or as identified by the governing law of the LIBOR contract, as appropriate to determine an ARR. Where a determining person does not select an ARR by the earlier of the LIBOR replacement date or the latest date for selecting an ARR according to the terms of the LIBOR contract, the LIBOR Act provides that the ARR for such LIBOR contract will be, by operation of law, the Board-selected ARR on and after the LIBOR replacement date. Where a determining person selects the Board-selected ARR as the ARR, the LIBOR Act provides that such selection shall be (i) irrevocable, (ii) made by the earlier of the LIBOR replacement date and the latest date for selecting an ARR according to the terms of the LIBOR contract, and (iii) used in any determinations of the benchmark under, or with respect to, the LIBOR contract occurring on and after the LIBOR replacement date.  Although the LIBOR Act does not require a determining person to select the Board-selected ARR as the ARR for a LIBOR contract, the LIBOR Act provides a series of statutory protections, enumerated in Section 105 of the LIBOR Act, for any determining person who makes a such selection, including protections against adverse claims or causes of action arising out of the selection of the Board-selected ARR as an ARR.

Where the Board-selected ARR becomes the ARR for a LIBOR contract, either by operation of law or via the selection of a determining person, the LIBOR Act contemplates that certain conforming changes to a LIBOR contract may be necessary to facilitate the transition from USD LIBOR to the Board-selected ARR. These “benchmark replacement conforming changes” may arise in one of two ways. First, the LIBOR Act authorizes the Board to determine benchmark replacement conforming changes that, at its discretion, would address one or more issues affecting the implementation, administration, and calculation of the Board-selected ARR in LIBOR contracts. Second, for a LIBOR contract that is not a consumer loan, a calculating person may, in their reasonable judgment, determine that benchmark replacement conforming changes are otherwise necessary or appropriate to permit the implementation, administration, and calculation of the Board-selected ARR under or with respect to a LIBOR contract after giving due consideration to any benchmark replacement conforming changes determined by the Board. For this purpose, the LIBOR Act defines “calculating person” to mean, with respect to any LIBOR contract, any person, including the determining person, responsible for calculating or determining any valuation, payment, or other measurement based on a benchmark.

Section 104 of the Act provides that all benchmark replacement conforming changes, whether determined by the Board or, if applicable, a calculating person, shall become an integral part of the LIBOR contract, and a calculating person is not required to obtain consent from any other person prior to adopting benchmark replacement conforming changes. In addition, the determination, implementation, and performance of benchmark replacement conforming changes are generally subject to statutory protections enumerated in Section 105 of the LIBOR Act, which is designed to ensure the continuity of the contract. Finally, where a calculating person implements or, in the case of a LIBOR contract that is not a consumer loan, determines the benchmark replacement conforming changes, the LIBOR Act provides that the calculating person is not subject to any adverse claim or cause of action.

The LIBOR Act includes various other provisions. Notably, Section 107 expressly preempts any provision of state law relating to the selection or use of a benchmark replacement or related conforming changes. Section 110 directs the Board to promulgate regulations to carry out the LIBOR Act not later than 180 days after enactment.

Proposed Rule

Pursuant to Section 110 of the LIBOR Act, on July 19, 2022, the Board invited comment on a proposal that provides default rules for certain contracts that use the LIBOR reference rate. The proposed rule would establish ARRs for contracts governed by U.S. law that reference certain tenors of U.S. dollar LIBOR (the overnight and one-, three-, six-, and twelve-month tenors) and that do not have terms providing for the use of a clearly defined and practicable ARR following the first London banking day after June 30, 2023. The contracts include the tough legacy contracts which, as noted above, are contracts that are governed by domestic law, that do not mature before LIBOR ends, and that lack adequate fallback provisions. The proposal identifies separate Board-selected replacement rates for derivatives transactions, contracts where a government-sponsored enterprise is a party, and all other affected contracts. As required by the law, each proposed replacement rate is based on SOFR.

The comment period ends on Aug. 29, 2022.

Conclusion

With the cessation of LIBOR, and only 10 months to June 30, 2023, lenders and market participants are encouraged (1) to perform an inventory of their current loan portfolios to identify LIBOR-based loans, (2) to evaluate possible ARRs (including SOFR, Term SOFR, Ameribor, and BSBY) to determine which would be appropriate given the size and types of loans and lenders’ capital positions, (3) to develop a plan to communicate critical information to their borrowers, (4) to take the steps necessary to equip their systems and software to handle the LIBOR transition, and (5) to discuss with legal counsel the actions that need to be taken, including the development of new form documents. If lenders and market participants delay in taking these actions, particularly in view of the LIBOR Act, difficulties and risk exposure will almost certainly follow rapidly.