On 19 July 2022, the Federal Reserve Board (the “Board”) published a notice of proposed rulemaking – Regulation Implementing the Adjustable Interest Rate (LIBOR) Act, as it was required to do by Section 110 of the Adjustable Interest Rate (LIBOR) Act (the “LIBOR Act”), which was signed into law on 15 March 2022.
In its related press release, the Board notes, “Consistent with the [LIBOR Act], the proposal would replace references to LIBOR in certain contracts with the applicable Board-selected replacement rate after June 30, 2023. The contracts include those governed by [US] 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 [LIBOR Act], each proposed replacement rate is based on the Secured Overnight Financing Rate.”
Summary of the Proposed Rule
After providing background context regarding LIBOR transition generally and the LIBOR Act specifically, the rulemaking notice discusses the proposed rule on a section-by-section basis. While much of the proposed rule tracks the language of the LIBOR Act, several important clarifications are proposed:
1. Definition of “business day”: The proposed definition tracks the “U.S. Government Securities Business Day” definition typically used in SOFR-referencing instruments, which relates to the settlement of the cleared Treasury repurchase agreements that underpin SOFR, but adds a fourth prong: “a day on which the Federal Reserve Bank of New York, with advance notice, chooses not to publish its Treasury repurchase agreement reference rates if participants in the Treasury repurchase agreement market broadly expect to treat that day as a holiday.” This addition facilitates the proposed linear methodology for implementing the benchmark replacement applicable to consumer loans during the one-year transition period contemplated by the LIBOR Act.
2. Applicability solely to US-law governed contracts: The proposed rule clarifies that both it and the LIBOR Act apply solely to “existing [LIBOR] contracts governed by federal law or the law of any state.” The LIBOR Act itself did not state expressly that it applied to contracts governed by US law only. The proposed rule also introduces a new definition of “state” that clarifies that the term “state” includes any US “state, commonwealth, territory or possession.” In its commentary to the proposed rule, the Board observed that, consistent with the purpose of the LIBOR Act, it is appropriate to define the term “state” expansively.
3. Applicability of the LIBOR Act to “covered” and “non-covered” contracts: Section 253.3 contains the operative language replacing LIBOR by operation of law on and after the “LIBOR replacement date” (the first London banking day after 30 June 2023 unless a tenor ceases to be published or is determined to not be representative prior to that date). For this purpose, the proposed rule defines the subset of LIBOR contracts in which LIBOR will be replaced by the Board-selected benchmark replacement by operation of law (i.e., LIBOR contracts that fall under either Section 104(a) or Section 104(c)(3) of the LIBOR Act) as “covered contracts.” As such, the term “covered contracts” under the proposed rule means contracts with one of the following characteristics: (i) no fallback provisions; (ii) fallback provisions that identify neither a specific benchmark replacement (including as a result of disregarding a rate that is based on a LIBOR value or depends on interbank rate polling) nor determining person (a person with the authority, right or obligation to select a benchmark replacement); or (iii) fallback provisions that identify a determining person but that person fails to select a benchmark replacement by the earlier of the statutory or contractual replacement date, unless, in each case, the contract parties elect in writing that the LIBOR Act not apply to their contract.
Section 253.3 also addresses the subset of LIBOR contracts that fall under Sections 104(c)(1) and 104(c)(2) of the LIBOR Act (i.e., LIBOR contracts for which a determining person selects the Board-selected benchmark replacement as the benchmark replacement), which do not fall within the proposed rule’s new definition of “covered contracts” and consequently constitute a subset of the newly defined category of “non-covered contracts” (“LIBOR contracts that are not covered contracts”), and confirms that a determining person may select the Board-selected benchmark replacement as the new benchmark on the terms provided by the LIBOR Act. With respect to this subset of non-covered contracts, while Section 253.3 itself does not confirm that a determining person that irrevocably selects the Board-selected benchmark replacement as part of an existing fallback provision is afforded the safe harbor protections of Section 105 of the LIBOR Act, the rulemaking notice clarifies that the Board (i) views the “statutory protections enumerated in section 105” of the LIBOR Act (i.e., the safe harbor provisions) as “self-executing;” and (ii) expects that “any” determining person “generally shall not be subject to any claim or cause of action in law or equity or request for equitable relief, or have liability for damages, arising out of the selection of the Board-selected benchmark replacement as a benchmark replacement.” As noted below, the Board seeks comment on whether the statutory safe harbor protections included in Section 105 of the LIBOR Act should be incorporated expressly into the final rule.
The rulemaking notice also proposes—and requests feedback with respect to—a clarification relating to a potential ambiguity affecting a different subset of “non-covered” LIBOR contracts, specifically, non-covered LIBOR contracts with fallback provisions that do not include a pre-cessation trigger relating to LIBOR becoming non-representative of its underlying market, and instead include only a trigger relating to a cessation or unavailability of LIBOR. Assuming that a “synthetic USD LIBOR” were produced and published in the future, as it has for GBP and JPY LIBOR, the ambiguity relates to whether, in that circumstance, LIBOR would have “ceased to be available” as a benchmark for this subset of non-covered LIBOR contracts, thus triggering a benchmark replacement.
Contemplating this case and question, the Board suggests that it would “promote the purposes of the LIBOR Act” (particularly the preclusion of disruptive litigation) if the final rule were to provide that on the earlier of the “LIBOR replacement date” and any contractual replacement date, LIBOR in any LIBOR contract included in this subset of non-covered LIBOR contracts (other than one the parties to which have opted out of the LIBOR Act) shall be replaced with the benchmark specified in the fallback language of such LIBOR contract. To be clear, such a clarifying regulatory provision would change the timing of the implementation of the applicable contractual benchmark replacement, but not the contractual benchmark replacement rate specified in the applicable fallback provision (i.e., a fallback to an Alternative Base Rate still would fall back to that rate, but on a date certain that is no later than the “LIBOR replacement date”). The precise language of this provision will depend on the feedback received by the Board to the rulemaking notice.
4. Board-selected Benchmark Replacements: Section 253.4 identifies the “Board-selected benchmark replacements” for four categories of contracts. Each replacement is based on SOFR and incorporates a static spread adjustment for each tenor, as set by ISDA on 5 March 2021 and prescribed by the LIBOR Act. For purposes of identifying the Board-selected benchmark replacement for each category, the proposed rule distinguishes between derivative transactions and cash products (i.e., non-derivatives), and, within cash products, further distinguishes among (a) consumer loans, (b) covered contracts to which government-sponsored entities (“GSEs”) are party and (c) all other cash products.
The Board-selected benchmark replacements identified in the proposed rule are:
- Derivatives (for contract parties that have not adhered to the ISDA 2020 IBOR Fallbacks Protocol) – compounded SOFR in arrears (Fallback Rate (SOFR)), as defined in the ISDA Protocol and calculated and published by, and licensed from, Bloomberg Index Services Limited;
- Non-GSE/non-Consumer Cash Transactions – overnight SOFR as published by the Federal Reserve Bank of New York, for overnight LIBOR, and Term SOFR published for one-, three-, six-, and 12-month tenors as administered by, and licensed from, CME Group Benchmark Administration, Ltd. (“CME Term SOFR”) for term LIBOR tenors;
- Consumer Loan Contracts – CME Term SOFR plus a “transition tenor spread adjustment” during the first year of transition beginning on the LIBOR replacement date (identified as “USD IBOR Cash Fallbacks” for “Consumer” products, as published and licensed by Refinitiv Limited, and deemed by the proposed rule to comply with the rule’s requirements), which is an amount that modifies the otherwise applicable ISDA spread adjustment to allow a linear transition for each business day during the first transition year from (i) the difference between the Board-selected benchmark replacement and the corresponding LIBOR tenor determined as of the day immediately before the LIBOR replacement date to (ii) the applicable tenor spread adjustment specified in the LIBOR Act (i.e., the ISDA spread adjustment) by the last day of the first transition year; and
- Covered GSE Contracts – overnight SOFR as published by the Federal Reserve Bank of New York, for overnight LIBOR, and the 30-calendar-day compounded average of SOFR, as published by the Federal Reserve Bank of New York (“30-day Average SOFR”) for term LIBOR tenors (to match the conventions for new SOFR-referencing multifamily loans and other structured product issued by GSEs since 2020, and to promote liquidity of both these and legacy products).
5. Conforming Changes: Section 103(4) of the LIBOR Act authorized the Board to determine “technical, administrative, or operational changes, alterations, or modifications” that would address issues affecting benchmark replacement implementation, administration or calculation. The commentary to the proposed rule states that the Board does not believe that any additional conforming changes are needed at this time for successful implementation of the Board-selected benchmark replacements set forth in the proposed rule, but Section 253.5(a) of the proposed rule reserves this discretionary authority. Similarly, Section 253.5(b) of the proposed rule retains the same authority for calculating persons in non-consumer LIBOR contracts, after due consideration of any Board-required changes.
6. Preemption: The proposed rule restates for clarity that the LIBOR Act and its implementing regulations preempt any provision of state law, as newly defined in the proposed rule, and local law that relates to the selection or use of a benchmark replacement or related conforming changes, or otherwise limiting the manner of calculating interest therewith.
7. Effective Date of Implementing Regulation: The proposed rule, if finalized, will become effective on the first day of the next calendar quarter that begins 30 days after publication of the final rule in the Federal Register.
Questions Presented for Comment
In addition to inviting general comments on the proposed rule, the rulemaking notice asks a number of specific questions, including the following:
a. Should the Board consider SOFR-based benchmark replacements or categories of covered contracts other than those identified in the proposed rule? Which alternative rates should be considered and why would they be better? Should the Board establish a single benchmark replacement for all categories of covered contracts?
b. What, if any, additional clarifications regarding benchmark replacements, covered contracts, and other defined terms should the Board consider including in the final rule and why would they be helpful?
c. As discussed above, should a clarifying trigger for non-covered contracts that lack a non-representativeness trigger be added to the proposed rule? Would other clarifications with respect to non-covered contracts be helpful?
d. Would additional clarifications with respect to the selection by determining persons of a benchmark replacement be helpful, particularly in the context of addressing litigation risks?
e. Are there specific benchmark replacement conforming changes that the Board should identify in the final rule, including any conforming changes specific to a category of covered contracts?
f. As has been proposed with respect to preemption, should the Board confirm in the proposed rule the statutory protections afforded by Section 105 of the LIBOR Act and, if so, are any clarifications needed?
Practical Observations about the Proposed Rule
As we think about the rulemaking notice and the questions it poses, a few preliminary observations come to mind:
1. Rulemaking deadline: Although Section 110 of the LIBOR Act requires that the Board promulgate regulations “not later than 180 days after the date of enactment,” we note that it is not uncommon for regulators, including the Board, to miss deadlines for finalizing rules. With a comment deadline of 29 August 2022, the final rule most likely will take effect 1 January 2023, which is later than the 180th day after enactment (11 September 2022), but “well in advance of the LIBOR replacement date,” as noted by the Board in the rulemaking notice.
In our view, completing the rulemaking process before the end of 2022 is important. Effectiveness of the final rule is required well in advance of 30 June 2023, among other things, to provide applicable deal parties sufficient and adequate time to make and implement benchmark rate and conforming changes decisions, and to update related operating systems. By way of example, the ARRC recommends in its LIBOR Legacy Playbook published 11 July 2022 that notices regarding the new benchmark for each transitioning transaction be made six months in advance of 30 June 2023 as a best practice.
2. Continued retention of authority to make conforming changes: Borrowers often ask why the ability to make conforming changes is retained in loan agreement amendments intended to implement the transition from LIBOR to SOFR and, presumably, make related conforming changes. The position of lenders typically is that because SOFR is a new rate, whose conventions and application may continue to evolve as it is implemented and used, it is not only appropriate, but necessary, to retain the ability to make additional conforming changes in the future. In Section II.E. of the rulemaking notice, the Board states that it does not believe that additional conforming changes are needed for the successful implementation of SOFR “at this time,” but it retains its discretionary authority to require additional conforming changes in the future “by regulation or order,” and notes the independent authority of calculating persons to determine conforming changes.
The lack of enumerated benchmark replacement conforming changes in the proposed rule is somewhat surprising, especially in light of the fact that the ARRC did include limited recommendations for benchmark replacement conforming changes—limited to lockouts, lookbacks, observation shifts, and payment delays—when asked to consider the same question for one-week LIBOR and two-month LIBOR for purposes of the New York state LIBOR statute in December 2021.
The Board does ask in its request for comment whether it should consider incorporating specific benchmark replacement conforming changes. Given that Section 253.5(a) of the proposed rule, consistent with the definition in Section 103 of the LIBOR Act, places discretionary authority to determine conforming changes solely in the Board for consumer contracts, and permits calculating persons in non-consumer contracts to implement additional conforming changes only after considering those established by the Board, one reasonably could expect the final rule to include some enumerated benchmark replacement conforming changes. However, we would expect that, should the Board determine to include specific conforming changes in the final rule, the conforming changes previously established by the ARRC for purposes of the New York LIBOR statute, as noted above, likely serve as a good proxy for the scope and type of conforming changes that the Board may determine to include in the final rule. A possible inclusion is the proposed rule’s new definition of “business day,” which might be a logical conforming changes designation given that all of the Board’s proposed Board-selected benchmark replacements are based on SOFR, as required by the LIBOR Act, and are written into contracts whose business day definition was drafted with the determination of LIBOR in mind, which follows a different business day convention.
3. LIBOR Act Section 105 statutory protections: As noted above, in its commentary to the proposed rule, the Board makes clear that it (i) views the “statutory protections enumerated in section 105” of the LIBOR Act (i.e., the safe harbor provisions) as “self-executing;” and (ii) expects that “any” determining person “generally shall not be subject to any claim or cause of action in law or equity or request for equitable relief, or have liability for damages, arising out of the selection of the Board-selected benchmark replacement as a benchmark replacement.” The Board nevertheless expressly requests comment as to whether the statutory protections in Section 105 of the LIBOR Act also should be incorporated into the final rule. We think that including a reference to the LIBOR Act statutory protections in the final rule, and confirming that the statutory protections apply to both “covered” contracts and “non-covered” contracts for which a determining person selects the Board-selected benchmark replacement, would be helpful.
4. Applicability of the LIBOR Act and proposed rule within the United States: Some have asked if the LIBOR Act and related regulations apply to all market participants or supervised institutions only (as is the case, for example, with the October 2021 joint statement of federal and state regulators regarding Managing the LIBOR Transition). The regulatory analysis in Section IV.A.c. of the rulemaking notice provides a clear answer: “Parties to covered contracts may include firms of any size and in any industry and are not limited to Board-regulated institutions or even firms engaged in financial activities.”
5. Applicability of the LIBOR Act and proposed rule outside the United States: The proposed rule eliminates any ambiguity about whether the LIBOR Act would apply to a USD LIBOR contract that is the subject of litigation in the United States, but that is governed by non-US law: the statute will not apply.
6. Synthetic USD LIBOR: The proposed rule, as well as other statements by the ARRC and the Board, appears to signal the likelihood that the UK Financial Conduct Authority (“FCA”) (with the implicit or explicit blessing of US regulators) will instruct ICE Benchmark Administration to publish so-called “synthetic” LIBOR for US dollars. The FCA published a consultation on the subject on 30 June 2022 (Consultation Paper CP22/11 – Winding down ‘synthetic’ sterling LIBOR and US dollar LIBOR – comments are due 24 August 2022), although the focus of a synthetic rate appears to be on USD LIBOR contracts that are not governed by US law.
The proposed rule was published in the Federal Register on 28 July 2022. Comments are due by 29 August 2022.
 “Not later than 180 days after the date of enactment of this Act, the Board shall promulgate regulations to carry out this division.”
 See Division U, pp. 777-786.
 See our prior legal updates The United States Adopts a Federal LIBOR Transition Solution (17 March 2022) and A Deeper Dive Into the US Adjustable Interest Rate (LIBOR) Act (4 April 2022)(“Deeper Dive”).
 See Deeper Dive for a detailed discussion of the LIBOR Act provisions.
 See Section 253.1(c) of the proposed rule.
 “State means any state, commonwealth, territory, or possession of the United States, the District of Columbia, the Commonwealth of Puerto Rico, the Commonwealth of the Northern Mariana Islands, American Samoa, Guam, or the United States Virgin Islands.”
 See also Section 253.3(b)(2) of the proposed rule. “Any such selection shall be (i) irrevocable; (ii) made by the earlier of the LIBOR replacement date or the latest date for selecting a new benchmark under the applicable LIBOR contract; and (iii) used in any determination of the benchmark in a LIBOR contract going forward.”
 See footnote 35 to the rulemaking notice.
 See footnote 28 to the rulemaking notice and related text.
 See Section 253.2 of the proposed rule. A covered GSE contract is defined as “a covered contract for which a GSE is identified as a party in the transaction documents and that is (i) a commercial or multifamily mortgage loan, (ii) a commercial or multifamily mortgage-backed security, (iii) a collateralized mortgage obligation, (iv) a credit risk transfer transaction, or (v) a Federal Home Loan Bank advance.”
 See Section II.G. of the rulemaking notice.
 See footnote 35 to the rulemaking notice.
 See footnote 28 to the rulemaking notice and related text.
 See Section 253.1(c).
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