Federal Law to the Rescue?

In each episode, dastardly Whiplash tweaks his mustache and tries to implement some nefarious scheme. Will Dudley do the right thing, as the defender of justice and fair play, by saving the day?[1]

Critical Issue

As the end of LIBOR approaches at full speed, Representative Brad Sherman (D-California) has introduced the “Adjustable Interest Rate (LIBOR) Act of 2021” (“H.R. 4616”)[2] and, on July 29, 2021, after consideration, the House Committee on Financial Services voted to further advance the bill.[3]

Will Federal legislation assure the ‘smooth transition’ from LIBOR insisted upon by banks and regulators and, ultimately, save the day, especially now that the UK Financial Conduct Authority (UK FCA) will likely require that no new USD LIBOR-based instruments be offered in 2022 (and beyond)? [4]

Background

At last count, there were approximately $223 trillion outstanding contracts referencing USD LIBOR.[5] Even if an estimated sixty-seven percent (67%) of these mature before USD LIBOR is set to be discontinued in June 2023, that still leaves “an estimated $74 Trillion” contracts outstanding (emphasis intentionally added).[6] Most of these “legacy” contracts do not contain clear “fallback language” – provisions that direct the parties upon LIBOR’s cessation and provide a transition to an alternate and equivalent interest rate.

Without fallback language, borrowers and lenders may try to negotiate new interest rates and spread adjustments, but any change to existing loan agreements may create tax issues, with new or forgiven income to be accounted for. Bond trustees, facing nearly $1.9 Trillion in exposures (emphasis intentionally added),[7] may not change interest rates without one hundred percent (100%) agreement from bondholders except in certain limited circumstances.[8]

New York Law Concerns

In April 2021, then-Governor Cuomo signed New York legislation into law (Assembly Bill A164B, the “New York LIBOR Law”), which provided a safe haven from litigation and prohibits parties from refusing to perform contractual obligations or declaring a breach of contract resulting from the discontinuance of LIBOR.[9]

However, the new law, nearly verbatim to the language proposed by the Alternative Reference Rates Committee (ARRC), a banker-heavy committee convened by the Federal Reserve Board and the New York Fed to find an alternative to LIBOR (i) only amends contracts governed by New York law and (ii) more critically, provides the ‘Get Out of Jail’ card[10] for banks, whether or not the recommended benchmark and spread adjustment are utilized.[11] The Alabama Legislature enacted parallel legislation governing Alabama contracts.[12]

New Proposed Federal Legislation

In March of this year, Federal Reserve Chair Jerome Powell and Treasury Secretary Janet Yellen advised Congress that the coming cessation of LIBOR necessitated Federal law to provide certainty and avoid liability and litigation.[13] H.R. 4616, if passed, would overrule the New York LIBOR Law (and Alabama law), and would provide the ability for bond trustees to change rates without violating the Trust Indenture Act. Its language is more borrower-friendly as the recommended benchmark (SOFR), as well as the recommended spread adjustment, have to actually be used in order for a bank to be absolved from liability.

SOFR So Good

The goal of H.R. 4616 is, by operation of law, to:

(a) establish a clear and uniform process, on a nationwide basis, for replacing LIBOR in existing contracts that do not provide for the use of a clearly defined fallback rate;

(b) preclude litigation for those contracts utilizing the recommended benchmark/spread adjustment; and

(c) allow existing contracts that include clearly defined fallback benchmark rates to operate according to the contract.

Upon its enactment, if a current LIBOR contract has no fallback benchmark rate replacement, H.R. 4616 authorizes a Determining Person (as in the New York LIBOR Law, generally the lender) to choose an appropriate replacement benchmark rate recommended by the “Board.”

Interestingly, while the New York LIBOR Law identifies the “Relevant recommending body” as among the Federal Reserve Board, the New York Fed, or ARRC (or their successors), H.R. 4616 identifies only the Board of Governors of the Federal Reserve System. In addition, only the Board of Governors would set any cap, floor, modifier, or spread adjustment that is deemed needed to make the replacement rate equivalent to the LIBOR rate it replaces.

If the Board-selected benchmark replacement rate is used, together with any Board-approved spread adjustments, there would be no Federal tax implications “as a sale, exchange or disposition of property for purposes of the Internal Revenue Code of 1986”.[14]

Importantly, H.R. 4616 would supersede all state laws regarding selection of benchmark replacements, including the New York LIBOR Law.

H.R. 4616 would also amend Section 316(b) of the Trust Indenture Act. The Trust Indenture Act currently states the right of any holder of a security to receive payment and interest “shall not be impaired or affected without the consent of such holder.” Under the proposed H.R. 4616, a bond trustee could alter the interest benchmark rate, and the right for the holder of a security to receive its interest shall not be deemed to be impaired or affected by any change occurring by the application of H.R. 4616.

BUT

No SOFR Options Even Being Offered

As discussed in July 2021[15], the ARRC’s Non-Financial Corporates Working Group, composed of approximately 100 public and non-public companies, investors, and borrowers wrote a letter of concern on April 27, 2021, to Messrs. Jerome Powell (Chair, Board of Governors of the Federal Reserve), John C. Williams (President and Chief Executive Officer, New York Fed), Gary Gensler (Chair, Securities and Exchange Commission (SEC)), Rostin Benham (Acting Chair, Commodities Futures Trading Commission (CFTC)), and Ms. Janet Yellen (Secretary, U.S. Department of the Treasury) (collectively, the “Official Sector Representatives”).[16] These Main Street end-users stated that nearly two-thirds had as yet been unable to receive detailed proposals or timelines from bankers as to replacement indices, and were “unable to negotiate current access to SOFR borrowings, even with large multi-year credit agreements nearing renewal.”[17]

Four months later, on August 23, 2021, after meeting with some representatives of the Non-Financial Corporates Working Group, a responsive letter was signed by each of the Official Sector Representatives.[18] They were “concerned to hear … that nonfinancial corporations are, in most cases, not yet being offered [LIBOR] alternatives despite the short amount of time left in the transition.” The Official Sector Representatives encouraged more “dialogue with your lenders” while stating that while “the official sector is not positioned to adjudicate the selection of reference rates between banks and their commercial customers, borrower preferences and needs clearly have a significant role to play in the selection of such rates.”[19]

Add to this the October 20, 2021, Joint Statement released by members of the Federal Reserve, Consumer Financial Protection Bureau (CFPB), Federal Deposit Insurance Corporation (FDIC), National Credit Union Administration (NCUA), Office of the Comptroller of the Currency (OCC), and State bank and credit union regulators.

They advised how supervised institutions should be managing the LIBOR transition and warned that the coming cessation of LIBOR was a significant event needing careful planning.[20] The Joint Statement recommended to lenders:

• there should be no new (and importantly, no extensions) of LIBOR-based instruments after December 31st

• best practices include clear internal governance and oversight

• supervised institutions are encouraged to develop and implement a transition plan for communicating with consumers, clients, and counterparties

This was not the first time such admonition was given. In November 2020, the Board of Governors of the Federal Reserve reiterated the following sentiment:

New contracts should either utilize a reference rate other than LIBOR or have robust fallback language that includes a clearly defined alternative reference rate after LIBOR’s discontinuation … Failure to prepare for disruptions to USD LIBOR, including operating with insufficiently robust language, could undermine financial stability and banks’ safety and soundness… [21]

To date, very few new bank contracts that we have reviewed reference a rate other than LIBOR or include fallback language that clearly defines a replacement reference rate that is not a reference rate chosen at the sole and absolute discretion of the lender.

If lenders take this strong admonition to heart to allay end-user concerns, in the New Year:

• legacy LIBOR-based instruments should be retired

• only instruments based on SOFR or other non-LIBOR based rates should be offered (rather than replacing LIBOR with LIBOR)

If this were to occur, there would therefore be no need for Dudley Do-Right to save the day…

Significant Spread Adjustments Concerns[22]

The International Swaps and Derivatives Association (ISDA) locked-in spread adjustments, on a worldwide basis, on March 5, 2021 (the “ISDA March 5th Spread Lock-In”). ISDA stated that the reason for doing so on March 5th was in response to the announcement on that day by the UK FCA regarding the future cessation and loss of representativeness of the LIBOR Benchmark.[23] This anticipated trigger announcement stated that certain LIBOR settings would cease after December 31, 2021, while some USD LIBOR settings would cease immediately following June 30, 2023.

However, the ISDA spread adjustment of 0.11448% for 1-month USD LIBOR (also reflected in Section 3(17) of H.R. 4616) made on March 5, 2021, more than 2-1/2 years before June 30, 2023, seems to be counterintuitive since LIBOR and SOFR rates, and the differential between them, presumably change on a daily basis.

What is, then, the effect of locking in a spread differential so far in advance?

Current Rates vs. March 5th Rates

Set forth below is a chart illustrating the spread differentials as of March 5th and October 15th:

A few questions to ponder:

• if March 5th is indeed the date to establish a standard spread adjustment differential, then, as per the above chart, shouldn’t the differential between SOFR and LIBOR be 0.06925%
• why does ISDA lock-in the spread, then, at 0.11448% (or 0.04523% higher)
• assuming this difference is justified on March 5th, why is it also justifiable on October 15th when the actual Differential is smaller (now 0.03038%), yet the ISDA March 5th Spread Lock-In remains the same higher rate, yielding a potential 0.08410% bonus to lenders

In other words, by utilizing the ISDA March 5th Spread Lock-In, the lender could be receiving an extra 4.5 to 8.4 basis points extra interest rate as a result of the LIBOR transition.[24] It is important to note to our avid fans, as highlighted in a much earlier episode in this series, LIBOR Panel Banks were alleged to have manipulated LIBOR which is the very reason for the transition from LIBOR to SOFR.[25]

[Cue ominous approaching locomotive sounds]

Methodology Concerns

          History vs. Future

The natural response is that one cannot utilize historical rates (SOFR’s 30-day average as calculated in arrears by the New York Fed) and forward-looking rates (1-month LIBOR). This would be an accurate statement. In fact, one of the primary concerns of SOFR is that it had been a rate calculated in arrears rather than a forward-looking rate. Now, CME Group will be publishing forward-looking rates to remedy this valid concern.

However, the ISDA March 5th Spread Lock-In uses a 5-year historical lookback period in its calculation (emphasis added). Shouldn’t:

• ISDA instead use future rates and, with CME Group calculating forward-looking rates, compared the two forward-looking rates to be the basis of the spread lock-in

• this “apples-to-apples” comparison be used in H.R. 4616, which legitimately grants lenders a safe harbor from litigation if the LIBOR transition does not economically disadvantage borrowers and other end-users

• any spread adjustment be calculated on a daily basis to deal with the different interest rate picture on March 5th and October 15th, much less between now and June 30, 2023

By using a 5-year median from March 5th, this historical lookback period actually captures the highest 5-year median LIBOR rate since the Great Recession. To be fair:

neither Bloomberg not ISDA makes any representations regarding whether the ISDA March 5th Spread Lock-In] will be appropriate for derivative or non-derivative financial Instruments. [26]

With respect to the 5-year lookback, SOFR had only been in existence for approximately 3 years prior to the ISDA March 5th Spread Lock-In. Consequently, ISDA utilized the indicative (pre-launch) SOFR values published by the New York Fed.[27] However, it is not clear that indicative rates should be used to calculate actual historical rates, to the extent even relevant when analyzing forward-looking rates, while these indicative SOFR rates are not publicly available from the New York Fed.

Lock-In vs. Daily Spread Adjustments

Maybe these concerns will be dealt with when the Federal Reserve establishes the spread adjustment referenced above in the proposed Federal legislation that it deems necessary to make the rate prior to and after the LIBOR transition equivalent.

Our guess is that they will be busy doing so since this should be done on a daily basis for many years to come.

Additional Words of Caution

Throughout his cartoon career, Dudley Do-Right, as the ‘defender of justice and fair play,’ never actually saved Nell – the real hero was his very intelligent horse. Just as the presumed locomotive approaches at full speed, creating a desire of Dudley to do right and save the damsel in distress, the coming loss of LIBOR may cause some irreparable harm to borrowers, as well as regional banks (who are, in essence, borrowers to ‘money-center’ banks).

Join Us Next Time to See:

• Do borrowers, regional banks, and bond trustees accept lender amendments to quickly-proffered documents during the LIBOR transition without thinking of the related legal and financial ramifications?

• Do Congress and regulators accept that the spread adjustments calculated by ISDA and included in H.R. 4616 are fair and reasonable?

• Do lenders offer only SOFR or other non-LIBOR based instruments in the next couple of months or just the all too familiar dastardly LIBOR?

• Do borrowers and smaller banks quickly find a reliable horse to navigate the LIBOR transition…before it is too late?

[1] Dudley Do-Right of the Mounties” segment of Rocky and Bullwinkle Show, created by Jay Ward, Alex Anderson, Allan Burns, and Chris Hayward.
[2] “H.R. 4616 — 117th Congress: Adjustable Interest Rate (LIBOR) Act of 2021,” last visited October 28, 2021.
[3] H.R. 4616 is also before the House Ways & Means Committee and the House Education and Labor Committee, as it also impacts legacy student loans.
[4] See also Client Alert entitled “ISDA 2020 IBOR Fallbacks Protocol”, October 26, 2020.
[5] See here.
[6] Progress Report: The Transition from U.S. Dollar LIBOR, The Alternative Reference Rates Committee March 31, 2021 Available here.
[7] Id., page 3, Note.
[8] For example, municipal bond indentures are exempt under the Trust Indenture Act; also see Client Alert entitled “The Effect of LIBOR Cessation on Bonds – What’s a Trustee to Do?”, May 12, 2021.
[9] See here. Last visited September 12, 2021
[10] See Monopoly Board Games, Card & Online Games - Hasbro Monopoly^TM board game from Hasbro, Inc., an American-Canadian multinational conglomerate headquartered in Pawtucket, Rhode Island.
[11] See Client Alert entitled “The End of LIBOR – The Twilight Zone^TM Edition,” March 11, 2021.
[12] Section 5-28-1 - Title, Ala. Code § 5-28-1.
[13] Hannah Lang, “Calls Intensify for Congress to Intervene on LIBOR,” American Banker, March 26, 2021, available here last visited September 12, 2021.
[14] However, pursuant to the provisions of H.R. 4616, it must still be vetted by the Internal Revenue Service.
[15] See Client Alert entitled “LIBOR Transition: Potential Higher Interest Rates and Resultant Job Cuts,” July 1, 2021.
[16] Center for Capital Markets Competitiveness, “Transitions to the Secured Overnight Financing Rate – The Views of Nonfinancial Corporations,” April 27, 2021.
[17] Id., Page 3.
[18] See here.
[19] Id.
[20] Id.
[21] See here.
[22] The following analysis utilizes 1-month USD LIBOR but is equally applicable to other USD LIBOR tenors and all Euro LIBOR tenors.
[23] See here.
[24] By way of comparison, the estimated manipulation of 1-month USD LIBOR during August 2007 to May 2010 was 19 basis points (see here), as agreed to by Class Counsel, the LIBOR Panel Banks and the Court in the LIBOR Class Action pending in the Southern District of New York (the “LIBOR Class Action”). See Second Consolidated and Amended Complaint, September 10, 2013, available here. See also Client Alert entitled “Recent Swap Manipulation Cases” February 23, 2021.
[25] See the section entitled “IV. A Brief Background of the LIBOR Scandal Relevant to the Objection” contained in the Citibank Objection, filed on January 2, 2018, in the LIBOR Class Action. Available here.
[26] IBOR Fallbacks: Technical Notice – Spread Fixing Event for LIBOR, circulated on March 5, 2021, a joint publication of ISDA and Bloomberg Finance L.P./Bloomberg Index Services Limited (collectively, “Bloomberg”). Available here.
[27] See Section 6.2 of the IBOR Fallback Rate Adjustments Rule Book, dated April 22, 2020, a joint publication of ISDA and Bloomberg. Available here.