The Board of Governors of the Federal Reserve System is proposing a regulation that would implement the Adjustable Interest Rate Act, better known as the LIBOR Act. The proposed rule, released on July 19, provides for separate replacement rates for derivatives transactions, contracts where a government-sponsored enterprise is a party and other certain affected contracts.
Banking regulators have been advising financial market participants to be proactive in addressing the LIBOR discontinuation since late 2020. With respect to contracts entered into prior to Dec. 31, 2021, banks were urged either to use a reference rate other than LIBOR or have clear fallback language that includes a defined alternative reference rate after LIBOR’s discontinuation. European regulators of the floating interest rate benchmark have announced that the publication of LIBOR for tenors of U.S. dollar-denominated LIBOR will cease after June 30, 2023.
Despite these measures, there are still a significant number of existing contracts that reference LIBOR, which will not mature by June 30, 2023 and cannot be easily amended. Of particular concern are so-called “tough legacy contracts,” which lack adequate fallback provisions providing for a clearly defined or practicable replacement benchmark following the cessation of LIBOR. In an effort to provide a uniform, nationwide solution for replacing references to LIBOR in tough legacy contracts, Congress passed the LIBOR Act.
The LIBOR Act lays out a set of default rules that apply to tough legacy contracts subject to U.S. laws.
Section 104, the act’s main operative provision, distinguishes between three categories of LIBOR contracts: (1) contracts that contain fallback provisions identifying a specific benchmark replacement that is not based in any way on any of the LIBOR Act’s 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; (2) contracts that contain no fallback provisions; and (3) contracts that contain fallback provisions authorizing a determining person to determine a benchmark replacement.
The Fed’s proposed rule prescribes guidance for each of these three categories.
Contracts that fall into the first category will transition to the contractually agreed-upon benchmark replacement on or before the LIBOR replacement date, which shall be the first London banking date after June 30, 2023.
Contracts that fall into the second category, so called “covered contracts,” will see the LIBOR benchmark replaced by a benchmark replacement rate identified by the Fed that is based on SOFR (which is referred to as the “Board-selected benchmark replacement”) on the LIBOR replacement date.
For contracts that fall into the third category the applicability of the LIBOR Act is subject to the determination, if any, made by the determining person. If the determining person does not select a benchmark replacement by the LIBOR replacement date, the LIBOR Act states the LIBOR benchmark shall be replaced by SOFR.
If the determining person selects SOFR as a new benchmark, that decision must be irrevocable, must apply on and after the LIBOR replacement date and must have been selected no later than the earlier of the LIBOR replacement date or the latest selection date authorized in the contract.
Possible Regulatory Impact
By providing a uniform, nationwide solution for replacing references to LIBOR in tough legacy contracts, the LIBOR Act aims to forestall costly and potentially disruptive litigation. Further, the automatic transition to the SOFR rate obviates the need for the laborious process of amending each tough legacy contract individually to replace the LIBOR reference rate.
The Fed’s proposed rule would not impose any reporting or recordkeeping requirements, nor require the parties to covered contracts to take any affirmative steps. Instead, the proposed rule would codify the provisions of Section 104 of the LIBOR Act, which replaces references to LIBOR in contracts with SOFR. Counterparties will not be required to consent to adopt the new benchmark and the determination, implementation and performance of SOFR are protected under Section 105 of the LIBOR Act and designed to ensure continuity of the contracts.
The change from LIBOR to SOFR will likely result in different amounts due under loan agreements. As a result, in the rule the Fed commented that the substitution of SOFR for LIBOR may have a “potentially significant economic impact on parties to covered contracts.”
Timothy Rennie and Kate Henry are associates in Boston law firm Nutter’s corporate and transactions department. Michael Krebs is co-chair of Nutter’s banking and finance practice group.