I. LIBOR Manipulation and SOFR as Its Replacement
On December 31, 2021, the New York Federal Reserve and U.K. Regulators began the process of phasing out the London Interbank Offered Rate (“LIBOR”) and replacing it with the Secured Overnight Financing Rate (“SOFR”).[1] The end of LIBOR and its replacement with SOFR has had, and will continue to have, a considerable impact on both existing and future contract negotiations. According to the Commodity Futures Trading Commission’s Market Risk Advisory Committee, as of July 2018, $200 trillion worth of financial contracts referenced USD LIBOR, 95% of which were made up of derivative contracts.[2] Additionally, there are approximately $3.4 trillion of LIBOR indexed non-syndicated commercial real estate mortgages, retail mortgages, and other consumer loans and mortgage-backed securities in the market.[3] In contracts with fallback provisions, the transition may be automatic upon the termination of LIBOR, or the fallback provision may require that the contract be actively amended by contracting parties.[4] However, some contracts – such as legacy contracts – do not contain fallback provisions and have maturity dates after LIBOR cessation.[5] As such, financial institutions and market participants should actively seek out contracts referencing LIBOR and make the necessary amendments to facilitate a more fluid transition.[6]
For more than 40 years, LIBOR, often referred to as “the world’s most important number,” was the primary benchmark for setting interest rates on a wide assortment of products such as credit default swaps, asset-backed securities, derivative contracts, adjustable-rate loans, and other types of debt.[7] LIBOR was published daily by the Intercontinental Exchange (“ICE”) Benchmark Administration, in five currencies: the U.S. Dollar, the Euro, the UK Pound Sterling, the Japanese Yen, and the Swiss Franc.[8] LIBOR was calculated by polling 18 banks active in London’s interbank, wholesale lending market, asking each bank “[a]t what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 a.m.?” [9] This reliance on the self-reporting of private banks presented a ripe opportunity for manipulation. In 2012, extensive investigations uncovered that multiple major banks were reporting significantly lower borrowing costs for LIBOR calculations than the banks were charging in practice.[10] By reporting lower borrowing costs, these banks were purporting to the public that they were doing better than they were in practice.[11] This was done to keep rates at their [the banks’]preferred levels.[12] While the banks responsible faced regulatory scrutiny following the scandal, perhaps the more substantial consequence was a long-lasting and damaging public distrust of the financial markets and LIBOR.[13] Consequently, it was decided that LIBOR was to be phased out and replaced with an alternative reference rate: SOFR.[14]
LIBOR’s replacement, SOFR is produced daily by the Federal Reserve Bank of New York and reflects the actual, retrospective cost of borrowing cash overnight using repurchase agreements, which are secured by U.S. Treasury securities.[15] In other words, SOFR comprises the weighted averages of the rates U.S. financial institutions pay each other for overnight loans, also known as repo transactions.[16] By reflecting transactions tied to U.S. Treasury securities, SOFR mitigates the risk for manipulation – compared to the forward-looking LIBOR – with some referring to it as a “risk-free rate.”[17] While the final deadline to replace LIBOR with SOFR – or an alternative reference rate – is set for June 30, 2023, the phasing out process has already begun.[18] As of December 31, 2021, the ICE Benchmark Administration (“IBA”) will cease publishing LIBOR for the following maturities: the Sterling, Euro, Swiss Franc, and Japanese Yen, as well as the one-week and two-month USD LIBOR.[19] However, LIBOR will continue to be published for overnight, one-month, three-month, six-month, and twelve-month maturities through June 30, 2023.[20] Furthermore, this transition from LIBOR to SOFR was endorsed by the New York State legislature when, tracking the language provided by the Alternative Reference Rates Committee (“ARRC”), former Governor Andrew Cuomo signed into law Senate Bill 297B/Assembly Bill 164B.[21]
II. Implications for Individuals, Contracts, and Businesses
The termination of USD LIBOR, and its replacement with SOFR, will have long-lasting implications on existing loans, derivatives contracts, legacy contracts, and other financial instruments; implications that lawyers for both borrowers and lenders will need to consider in amending existing contracts and drafting future contracts.[22] In discussing key focus areas for the ARRC, Vice Chairman of Institutional Securities at Morgan Stanley and Chairman of ARRC Tom Wipf emphasized that financial institutions and market participants must “renegotiate and amend existing contracts where possible to move away from LIBOR or to incorporate robust fallback language that contemplates a permanent end to LIBOR, such as the ARRC’s recommended fallback language.”[23] For new contracts and contracts with fallback provisions, in its published Year-End Progress Report, ARRC put forth two separate approaches: (1) a “hardwired” approach and (2) a “wait and see” or “amendment” approach.[24] Under the hardwired approach, the USD LIBOR is automatically replaced with a specific rate, such as SOFR, upon the occurrence of one of the pre-determined triggers.[25] Under the wait-and-see (or amendment) approach, which only applies to bilateral and syndicated loans, the lender and borrower are required to amend the loan upon the occurrence of a triggering event and adopt a new rate to be identified at such time.[26] Regardless of the approach taken, in-house counsels and compliance teams should be vigilant about tracking financial products and ensuring that all contracts, specifically legacy contracts, are suitably amended or renegotiated to ensure a smooth transition.
III. Legislative Response
While the ARRC had made significant strides in recommending fallback language for new contracts and existing contracts with fallback provisions, the ARRC also recognized that not all contracts can be amended by the June 30, 2023, LIBOR cessation deadline.[27] While contracts with fallback provisions may leave contracting parties with no choice but to replace LIBOR with SOFR or an alternative reference rate, a sufficient number of legacy contracts – contracts that reference USD LIBOR as a benchmark interest rate but do not include adequate fallback provisions and will remain in existence beyond June 30, 2023–[28] may prove to be problematic.
In March 2021, the transition from LIBOR to SOFR was endorsed by the New York State legislature when, tracking language provided by the ARRC, former Governor Andrew Cuomo signed into law the Libor Transition Bill (Senate Bill 297B/Assembly Bill 164B).[29] The New York law mandates that come June 30, 2023, all contracts, including legacy contracts, that reference LIBOR as a benchmark rate will be automatically amended so that LIBOR is replaced by the “recommended benchmark replacement,” which has been determined to be SOFR, plus a spread adjustment.[30] In addition, parties to a legacy contract governed by New York law may not refuse to perform their obligations, declare a breach of contract, or recover damages as a result of the discontinuance of USD LIBOR.[31] The new law also provides a “safe harbor” from litigation where SOFR is selected as a replacement rate for LIBOR.[32] However, as the language of the law indicates, parties are not required to transition to SOFR; parties can agree to an alternative, non-SOFR reference rate.[33] In enacting the bill, the New York State Legislature facilitates the transition from LIBOR to SOFR by reducing legal uncertainties posed by legacy contracts that cannot be amended to adequately address the termination of USD LIBOR.
III. Conclusion
The replacement of LIBOR with SOFR will affect trillions of dollars’ worth of financial instruments and derivative contracts.[34] Despite the safeguards put in place by New York State Legislatures through Senate Bill 297B/Assembly Bill 164B, it would be wise for attorneys to take proactive measures in seeking out and amending existing contracts, specifically legacy LIBOR contracts. The safeguards under the new law should serve merely as a last resort backstop if adequate fallback language is not agreed upon prior to the cessation date. Given the June 30, 2023, LIBOR deadline, financial institutions and market participants have ample time to take the proactive steps required to minimize market disruption.
[1] ICE Benchmark Administration, LIBOR, ICE, https://www.theice.com/iba/libor (last visited Feb. 15, 2022).
[2] Peter E. Fisch & Mitchell L. Berg, Considerations for LIBOR’S Replacement in the Real Estate Loan Market, New York L.J. (Feb. 11, 2020), https://www.law.com/newyorklawjournal/2020/02/11/considerations-for-libors-replacement-in-the-real-estate-market/.
[3] Id.
[4] Alternative Reference Rates Comm., Year-End Progress Report: The Transition from U.S. Dollar LIBOR, Fed. Rsrv. Bank N.Y. (Dec. 2021), https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2021/20211216-usd-libor-year-end-transition-progress-report.
[5] Id.
[6] James Hardy, et. al., Term SOFR: a non-US Market Perspective, White & Case (Dec. 7, 2021), https://www.whitecase.com/publications/alert/term-sofr-non-us-market-perspective (last visited Feb. 15, 2022).
[7]Paul Cantwell et. al., Changing the World’s Most Important Number, Oliver Wyman, 2 (2018), https://www.oliverwyman.com/content/dam/oliver-wyman/v2/publications/2018/February/LIBOR-transition-POV-FINAL.pdf.
[8] Fisch, supra note 2.
[9] Id.
[10] Carrick Mollenkamp & Mark Whitehouse, Study Casts Doubt on Key Rate, Wall St. J. (May 29, 2008, 12:01 a.m.), https://www.wsj.com/articles/SB121200703762027135.
[11] Id.
[12] Id.
[13] James McBride, Understanding the Libor Scandal, Council on Foreign Relations (Oct. 12, 2016, 8:00 a.m.), https://www.cfr.org/backgrounder/understanding-libor-scandal (last visited Feb. 15, 2022).
[14] Hardy et. al., supra note 4.
[15] Fisch, supra note 2.
[16] Marquit, What is LIBOR and Why Is It Being Abandoned?, supra note 8.
[17] Fisch, supra note 2.
[18] ICE Benchmark Administration, supra note 1.
[19] Id.
[20] Id.
[21] S. 297B, 2021 Leg., Reg. Sess. (N.Y. 2021).
[22] Alternative Reference Rates Comm., supra note 5.
[23] Tom Wipf, The World’s Most Important Number is Done. The Work to Replace it Continues, Barron’s (Feb. 3, 2022, 3:00 a.m.), https://www.barrons.com/articles/the-worlds-most-important-number-is-done-the-work-to-replace-it-continues-51643834226.
[24] Alternative Reference Rates Comm., supra note 5.
[25] Id.
[26] Id.
[27] Id.
[28] Id.
[29] S. 297B, 2021 Leg., Reg. Sess. (N.Y. 2021).
[30] Id.
[31] Id.
[32] Id.
[33] Marc Gottridge, Evan Koster, and Deborah Staudinger, New York Paves the Way for LIBOR Transition, 2021 WL 1620965.
[34] Fisch, supra note 2.
