Introduction
President Biden on March 15, 2022 signed into law the Adjustable Interest Rate (LIBOR) Act (the “LIBOR Act”), long-awaited federal legislation to address the potential disruption of contractual continuity and litigation risk posed by financial instruments that incorporated US Dollar LIBOR as a term for the payment of interest but lacked a workable – or in some cases, any – “fallback” rate to replace LIBOR in the event of its cessation, which is now a reality. Such contracts will now be amended by operation of law so as to replace benchmarks based on LIBOR with a rate based on the Secured Overnight Financing Rate (SOFR), unless an eligible person under the contract already has designated another benchmark for the contract or it has been amended by the parties. The federal legislation – part of the massive Consolidated Appropriations Act, 2022 – fills a void that until recently had been only partially filled by state laws aimed at addressing the same problem and will decrease risks of default and litigation. The law directs the Board of Governors of the Federal Reserve to issue regulations to carry out its mandate within 180 days.
Background
LIBOR, long the preeminent global interest-rate benchmark, ended as of December 31, 2021, in nearly all currencies and tenors (maturities) – and although regulators granted US Dollar LIBOR in several tenors a temporary reprieve, it too is scheduled to end after June 30, 2023. The transition from LIBOR to “risk free rates” such as SOFR for US Dollars and the Sterling Overnight Interbank Average (SONIA) for UK Sterling has largely been successful. Legislators and regulators, however, have been understandably concerned about the potential disruption of contractual continuity and litigation risk posed by contracts (called “tough legacy” contracts) that incorporated LIBOR as a term for the payment of interest but lacked a workable (or in some cases, any) fallback rate to replace LIBOR in the event of its cessation.
Many contracts and financial instruments, mainly entered into years before LIBOR’s termination was contemplated, incorporate LIBOR as a term but lack provisions to replace LIBOR with a different rate. Some contain no fallback in the event that LIBOR is no longer published, while others contain fallbacks that are not workable, such as a provision for a LIBOR-like polling of reference banks for their cost of funds. Still others contain “fallbacks” that on their face could dramatically alter the economics of a transaction – e.g., by requiring reversion to the last available LIBOR screen rate or last published LIBOR. And although many “legacy” contracts lacking practical fallbacks have been or may yet be amended through negotiations between the parties, that is not always possible. In some cases, parties may be unwilling or unable to negotiate an amendment.
The persistence of these “tough legacy” contracts after LIBOR’s discontinuance creates the potential for litigation and market disruption. Parties to such contracts may seek to unwind them based upon arguments such as frustration of purpose, force majeure, impossibility or impracticability of performance and the like. That could leave counterparties uncertain as to whether they are still subject to binding obligations and if so, on what terms. Of course, such litigation will result in all parties bearing significant litigation expense. Although the extension of the end-date for US Dollar LIBOR in the most frequently used tenors, until after June 30, 2023, undoubtedly has reduced the scope of the problem, real and significant risks remained.
To mitigate those risks, several jurisdictions had adopted legislative and/or regulatory “fixes.” For example, in April 2021, the New York Legislature amended the state’s General Obligations Law specifically to address the end of US Dollar LIBOR. The LIBOR Act is similar to the New York law, although the latter law affects only New York law instruments.
The Adjustable Interest Rate (LIBOR) Act
Starting on the relevant LIBOR replacement date (the first London banking day after June 30, 2023 for LIBOR in most tenors), the LIBOR Act automatically invalidates contractual fallback provisions that (i) are based on US Dollar LIBOR or (ii) involve polls, surveys and inquiries. Where such a provision has been invalidated, or where a contract subject to the law contained no fallback provision at all, SOFR plus a spread adjustment – the “Board-selected benchmark replacement” – automatically becomes the fallback, unless a “Determining Person” under the contract (e.g., a trustee or calculation agent having contractual authority to determine a replacement rate) already has designated another benchmark for the contract or it has been amended by the parties.
Where LIBOR is thus replaced by the recommended benchmark replacement rate, federal law now declares the SOFR-based replacement a “commercially reasonable replacement for and a commercially substantial equivalent to LIBOR,” and a “reasonable, comparable or analogous rate, index, or term for LIBOR.” These provisions go far to guarantee continuity of contract.
The law also expressly creates a safe harbor against litigation. If a “Determining Person” replaces LIBOR with the SOFR-based replacement in the circumstances specified in the statute, that action shall not “be deemed to impair or affect the right of any person to receive a payment, or to affect the amount or timing of such payment, under any LIBOR contract,” and the Determining Person shall not be subject to any claim or cause of action arising out of the selection or use of such a replacement. And selection of a Board-selected benchmark replacement shall not discharge or excuse performance of the contract “for any reason, claim or defense”; justify the termination or suspension of a party’s performance; constitute a breach of contract; nor void or nullify any LIBOR contract.
The LIBOR Act also includes language that modifies benchmark spread adjustments applicable to consumer loans for a one-year period.
Because the federal law supersedes and pre-empts state laws previously enacted to address LIBOR cessation, including the New York law enacted last year, it will provide for consistent results throughout the United States. This will lead to greater certainty in the marketplace and less likelihood of litigation.
For further information, please contact:
Lisa Fried, Partner, Herbert Smith Freehills
