Shearman And Sterling

Derivatives, Financial Chart

Apr 01, 2020

ARRC Releases NY Law Proposal To Amend Transactions Referencing USD LIBOR

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ARRC RELEASES NY LAW PROPOSAL TO AMEND TRANSACTIONS REFERENCING USD LIBOR

On March 6, 2020, the Alternative Rate Reference Committee (ARRC), the Federal Reserve’s LIBOR-transition working group comprised of private-sector entities and industry regulators, released its New York State legislative proposal for amending financial contracts that lack adequate fallback language.[1] The proposed New York law would apply to certain LIBOR-based financial contracts executed prior to LIBOR’s discontinuation and amend them, by operation of law, to include ARRC’s recommended fallback rate plus a spread adjustment. ARRC drafted the law to provide legal certainty and to minimize the potentially adverse economic consequences associated with the industry’s transition away from LIBOR.

Background: ARRC’s Fallback Language and Replacing LIBOR

LIBOR is predicted to be discontinued by the end of 2021. However, a substantial number of financial contracts reference LIBOR, most of which do not include provisions (known as “fallbacks”) that provide an alternative benchmark rate in the event that LIBOR is temporarily or permanently discontinued. To address this issue, ARRC has (1) recommended a Secured Overnight Financing Rate (SOFR)[2] rate plus a spread adjustment to replace LIBOR and to operate as a fallback, (2) released a transition plan promoting the use of SOFR voluntarily and (3) conducted five market-wide consultations to determine how best to implement SOFR-based fallback language into existing LIBOR-based financial contracts.

Through those consultations, ARRC observed that many market participants were unable to amend their existing agreements to remove LIBOR-based fallback language. Several products, including floating rate notes, securitizations, consumer adjustable rate mortgages, derivatives, business loans, procurements and municipal bonds, contain procedural and substantive barriers that complicate amending the agreements underlying them. Accordingly, primarily because (1) a substantial number of financial contracts referencing USD LIBOR are governed by New York law, and (2) amending bilaterally has proven challenging, ARRC’s proposal for implementing its recommended fallback provisions is a New York law that would legislatively incorporate ARRC fallbacks into existing (“legacy”) contracts. Legislative action is expected to provide help maintaining consistency and financial stability for consumers, businesses, lenders and investors and reduce the burden on New York courts that would otherwise arise from disputes relating to contracts referencing LIBOR.

The Legislative Proposal: Key Takeaways

The proposed legislation activates when either (1) a “permanent cessation trigger” occurs, or (2) a “pre-cessation trigger” occurs. A permanent cessation trigger is defined as a public statement by the administrator of LIBOR—or the administrator’s regulator—announcing that LIBOR has ceased or will cease. A pre-cessation trigger is defined as a public statement by the regulator of LIBOR’s administrator announcing that LIBOR is no longer available.

At its core, the proposed legislation:

  • prohibits a party from refusing to perform its contractual obligations, or declaring a breach, as a result of LIBOR discontinuation or the use of the legislation’s recommended benchmark replacement rate;
  • establishes that the recommended benchmark replacement is a commercially reasonable substitute for, and a commercially substantial equivalent to, LIBOR; and
  • provides a safe harbor from litigation for the use of the ARRC-recommended benchmark replacement rate.

To accomplish these objectives, the proposed legislation has mandatory and permissive application depending on the nature of the agreement.

On a mandatory basis, the proposed legislation:

  • overrides legacy fallback language that references a LIBOR-based rate (such as “last quoted LIBOR”) in favor of the legislation’s recommended benchmark rate;
  • nullifies legacy fallback language that requires polling for LIBOR or other interbank funding rates; and
  • inserts the legislation’s recommended benchmark replacement as the LIBOR fallback in legacy contracts that do not contain fallback language.

There is no override of legacy fallback language that expressly references a non-LIBOR-based rate (e.g., the prime rate) as is common in business loans.

On a permissive basis, the proposed legislation:

  • allows parties with the right to select their agreements’ governing fallback rates to avail themselves of the litigation safe harbor if they select the ARRC-recommended benchmark replacement rate; and
  • permits parties to mutually opt out of the proposed legislation’s mandatory application at any time.

The proposed legislation does not categorically exclude any product from its definitions. Accordingly, ARRC encourages parties for whom the legislation is not effective to exercise their opt-out rights and negotiate bilaterally. Further, the statute would provide safe-harbor protection with respect to conforming changes in documents made to accommodate administrative/operational adjustments for the statutory endorsed benchmark rate.

The proposed approach was based partly upon New York legislation enacted in 1998 to address the discontinuation of sovereign currencies being replaced by the euro.

Application of the Legislative Proposal to Particular Products

Several financial products have procedural and substantive aspects that complicate or prevent amending the underlying legacy contracts on which they are based. The proposed legislation would provide a solution for these products by amending their LIBOR-referencing fallback provisions statutorily.

Product Type

Post-LIBOR Result for Legacy Contracts Without Proposed Legislation

Post-LIBOR Result for Legacy Contracts With Proposed Legislation

Floating Rate Notes

Polling or, if not available, the last available LIBOR. Floating rates could be converted inadvertently to fixed rates due to LIBOR’s discontinuation. Unanimous holder consent to amend fallback provisions referencing LIBOR.

Automatic override of references to interbank polling and nullification of language referencing the last available LIBOR in favor of the ARRC-recommended fallback rate, which is closer to the originally agreed upon rate.

Securitizations

Generally, reversion to a fixed rate based on the last LIBOR. Amendment through noteholder vote, many of which require unanimous consent. The transition is complicated by the fact that many securitizations involve different tranches, and many other underlying instruments (i.e., securities, derivatives, etc.) in a securitization will not fallback to the last LIBOR, creating a high basis risk among the rates.

Automatic override of any existing fallback language in favor of the legislation’s recommended fallback rate, which would more closely match the indices on the underlying assets or loans, and minimizes basis risk.

Consumer Adjustable Rate Mortgages (ARMs)

Generally determined at the discretion of the lender. No standardized or defined replacement rate, though lenders are typically obligated to consider “comparable information.” This could result in disparate outcomes and divergent rates.

Allows lenders to receive a litigation safe harbor if they choose to opt in to the legislation’s recommended fallback language for ARMs.

Derivatives

Currently, the calculation agent is obligated to poll reference banks, which is expected to fail once LIBOR no longer exists. There is no further fallback, which could lead to litigation. The proposed ISDA protocol binds only adhering parties and there is concern that end-users exempt from clearing requirements may opt out of adhering to the protocol.

Nullification of existing fallback references in favor of the legislation’s recommended fallback rate, which will be consistent with the ISDA protocol, and reduces uncertainty and operational risks among counterparties.

Business Loans (Bilateral and Syndicated)

May require polling from one or more reference banks, but if no rate is obtained, typically falls back to prime rate or a rate that is close to prime rate. More recent loans, particularly syndicated loans, allow parties to select and implement a replacement benchmark, and convert to an alternative base rate if no consent achieved.

Does not affect the loans to the extent that the loans fall back to a non-LIBOR replacement, but will nullify any reference to bank polling and override silent and ambiguous fallback provisions.

Procurement Agreements

Generally, no existing fallback and parties left to negotiate a mutually acceptable resolution or litigate matter. Suspension of deliveries and payments in the interim may disrupt the economy.

Fallback to the legislation’s recommended fallback rate.

Municipal Bonds

Maturity dates often extend well beyond 2021 and insufficient fallback language to address LIBOR discontinuation, creating potential rate uncertainty and litigation for taxpayers and municipalities.

Fallback to the legislation’s recommended fallback rate.

Next Steps

While it was initially believed that the proposed bill would be folded into the New York State budget bill, with the hope that it would be included in the round of bills incorporated into the budget on April 1, there are now doubts that the bill will be passed by the June 2 recess due to the current expectation that the legislature will be focused on COVID-19-related matters. While it is now unclear when the New York State Legislature will consider this matter, the bill is not expected to be particularly controversial. Once passed, however, to the extent impacted instruments are also subject to federal legislation, such as the Trust Indenture Act of 1939, which could in certain instances potentially conflict with the proposed state legislation, it is not yet clear what the implications of this may be.

ARRC intends to schedule a webinar within the next few weeks in order to further explain its proposed legislative solution, the details of which will be published on the ARRC website.

Footnotes

[1]  ARRC Executive Summary of Proposed Legislative Solution to LIBOR Transition, March 6, 2020; ARRC Proposed Legislative Solution Press Release, March 6, 2020.
[2]  SOFR is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities in repurchase markets. The Federal Reserve Bank of New York began publishing SOFR in 2018.

Authors and Contributors

Donna Parisi

Partner

Derivatives & Structured Products

+1 212 848 7367

+1 212 848 7367

New York

Geoffrey Goldman

Partner

Derivatives & Structured Products

+1 212 848 4867

+1 212 848 4867

New York

Tomasz Kulawik

Partner

Finance

+1 202 508 8041

+1 202 508 8041

Washington DC

Jennifer Oosterbaan

Associate

Derivatives & Structured Products

+1 212 848 7111

+1 212 848 7111

New York