On March 6, 2020, the Alternative Reference Rates Committee (ARRC) released its “Proposed Legislative Solution to Minimize Legal Uncertainty and Adverse Economic Impact Associated with LIBOR Transition,” which the ARRC intends to minimize legal uncertainty and adverse economic impacts associated with LIBOR transition.
The ARRC noted, in connection with the release of the proposal, that many financial contracts referencing LIBOR do not envision a permanent or indefinite cessation of LIBOR. Therefore, existing contracts1 either do not have fallback language that adequately addresses a permanent LIBOR cessation or have language that could dramatically alter the economics of contract terms if LIBOR is discontinued. Although existing contracts may be amended, such an amendment process might be challenging, if not impossible, for certain products. The ARRC proposes New York State legislation to address this issue because a substantial number of financial contracts that reference US dollar LIBOR are governed by New York law.
In summarizing the proposal, the ARRC stated that the proposed legislation would:
- prohibit a party from refusing to perform its contractual obligations or declaring a breach of contract as a result of LIBOR discontinuance or the use of the legislation’s recommended benchmark replacement;
- establish that the recommended benchmark replacement is a commercially reasonable substitute for and a commercially substantial equivalent to LIBOR; and
- provide a safe harbor from litigation for the use of the recommended benchmark replacement.
Specifically, the proposed legislation, on a mandatory basis, automatically would:
- override existing fallback language that references a LIBOR-based rate (such as last-available LIBOR) and instead would require the use of the legislation’s recommended benchmark replacement;
- nullify existing fallback language that requires polling for LIBOR or other interbank funding rates; and
- insert the recommended benchmark replacement as the LIBOR fallback in contracts that do not have any existing fallback language.
The proposed legislation also, on a permissive basis, would allow:
- parties who have the contractual right to exercise discretion or judgment regarding the fallback rate to avail themselves of the litigation safe harbor if they select the recommended benchmark replacement as the fallback rate; and
- parties to mutually opt out of any mandatory application of the proposed legislation, at any time.
However, while this legislative solution is obviously well-intentioned, one cannot help but wonder whether, if enacted as proposed, it would actually serve to “minimize legal uncertainty and adverse economic impact associated with LIBOR transition.” Unfortunately, there are several reasons why it might not or may not for a significant number of cases realize such intent.
One possible reason why the legislation may not be effective, especially at avoiding litigation entirely, is the possible conflict between such legislation and federal law contained in section 316(b) of the Trust Indenture Act of 1939, as amended (TIA)2. Holders of notes that are subject to the TIA may argue that changes in interest rates are precisely the sort of modification that requires unanimous consent under the statute.
Another similar conflict may exist for other legacy LIBOR-based transactions that require the consent of all holders for a change in the related interest rate or of holders that are “adversely affected” by such change, as is a common standard for many non-TIA qualified indentures.
Taking the second of these first, the NYS legislation proposed by the ARRC would provide that the use of a Recommended Benchmark Replacement or the implementation or performance of Benchmark Replacement Conforming Changes shall be deemed to (a) not be an amendment or modification of any contract, security or instrument and (b) not impair or have a material or adverse effect on any person’s rights or obligations under or in respect of any contract, security or instrument. While we understand that the APPR proposal is based on a NYS law passed in 1998 to deal with similar issues arising from the introduction of the Euro3, this is an unusual exercise of legislative power. Can the NYS legislature so change actual reality? To illustrate this point and reframe the provision in more neutral terms (and assuming that it wanted to do so), could the legislature similarly declare that borrowers may pay half of the contractual interest rate? Might this litigation “safe harbor” generate litigation over such issue?
The possible TIA conflict is at least more concrete. For TIA-qualified indentures that include section 316(b) language, the question becomes this: Is a change in rate effected by the proposed law an impermissible “impairment” or “affect” upon the contractual rate and, further, that if it is or might be, is the replacement of the contractual rate with the replacement benchmark rate an impermissible “impairment” or “affect” under the TIA? Of course, the ARRC proposal applies only for a Recommended Replacement Benchmark and only protects Benchmark Replacement Conforming Changes. As defined in the proposal, these are:
“Recommended Benchmark Replacement” shall mean a Benchmark Replacement, which shall include any Recommended Spread Adjustment and any Benchmark Replacement Conforming Changes, that shall have been selected or recommended by a Relevant Recommending Body.
“Benchmark Replacement Conforming Changes ” shall mean, with respect to any contract, security or instrument, any changes, alterations or modifications that are associated with and reasonably necessary to the use, adoption or implementation of a Recommended Benchmark Replacement and that (a) have been selected or recommended by a Relevant Recommending Body to reflect the use, adoption or implementation of a Recommended Benchmark Replacement under or in respect of such contract, security or instrument or (b) would not, in the reasonable judgment of the Determining Person, result in a disposition of such contract, security or instrument for U.S. federal income tax purposes.
Importantly, both of these terms require action (selection or recommendation, as applicable) by the Relevant Recommending Body, which is defined in the proposal as:
“Relevant Recommending Body” shall mean the Federal Reserve Board, the Federal Reserve Bank of New York, or the Alternative Reference Rates Committee or any successor to any of them.
However, the potential for dispute regarding whether the conforming changes are covered or whether the judgment of the Determining Person was reasonable would remain unless the Relevant Recommending Body makes such selection or recommendation and only those conforming changes are made.
Since it appears likely that the ARRC will only recommend SOFR-based Benchmark Replacements and only specific Benchmark Replacement Conforming Changes (which at least to date have not been taken up by the market for all products), any other replacement rates or other changes may not avoid the need for otherwise required consents to, or approvals of, such changes.
We note that, at this point, a companion federal legislative solution is not envisaged. Compliance Week reports that in a speech to the House Committee on Financial Services on February 11, 2020, Federal Reserve Chair Jerome Powell stated that he does not believe that a federal law change is needed.
While the ARRC proposal is an important step to manage the significant economic and related legal risks to LIBOR replacement, it may not necessarily be sufficient to accomplish the stated intent to minimize legal uncertainty and adverse economic impacts associated with LIBOR transition.
1 An estimated $2.5 trillion of LIBOR-based legacy transactions are expected to be still outstanding at the end of 2021, when publication of LIBOR will no longer be required by applicable regulators and many current providers of the underlying estimates for LIBOR are expected to cease providing such estimates.
(b) Prohibition of impairment of holder’s right to payment. Notwithstanding any other provision of the indenture to be qualified, the right of any holder of any indenture security to receive payment of the principal of and interest on such indenture security, on or after the respective due dates expressed in such indenture security, or to institute suit for the enforcement of any such payment on or after such respective dates, shall not be impaired or affected without the consent of such holder, except as to a postponement of an interest payment consented to as provided in paragraph (2) of subsection (a), and except that such indenture may contain provisions limiting or denying the right of any such holder to institute any such suit, if and to the extent that the institution or prosecution thereof or the entry of judgment therein would, under applicable law, result in the surrender, impairment, waiver, or loss of the lien of such indenture upon any property subject to such lien.
3 See New York’s General Obligation Law Article 5 Title 16 (available at: http://public.leginfo.state.ny.us/lawssrch.cgi?NVLWO).