On 6 March 2020 the Alternative Reference Rates Committee (ARRC) announced a proposal for a New York State Law to cover US LIBOR contracts that are governed by New York law. The rationale behind the new law is to try and minimise litigation and basis risk between contracts when US LIBOR ceases to exist at the end of 2021.

Background

In July 2014 the Financial Stability Board published a paper “Reforming Major Interest Rate Benchmarks” to address the issues caused by the manipulation of benchmarks, false reporting of global reference rates, together with the post-crisis decline in liquidity in interbank unsecured funding markets. The Financial Stability Board recommended establishing alternative risk-free rates (RFRs) for use instead of LIBOR-style reference rates.

To address risks related to USD LIBOR, the Federal Reserve Board and the Federal Reserve Bank of New York jointly convened the ARRC, which is chaired by Tom Wipf of Morgan Stanley, in 2014. The ARRC identified the Secured Overnight Financing Rate (SOFR) benchmark, which is administered by the Federal Reserve Bank of New York, as their preferred RFR. The ARRC is now focused on how to transition away from US LIBOR to SOFR.

The Sterling Risk-Free Reference Rates Working Group (RFRWG) was established in 2015 to develop alternative RFRs in place of GBP LIBOR-style reference rates and is chaired by Barclays Bank. In April 2017, the RFRWG recommended the Sterling Overnight Interbank Average Rate (SONIA) benchmark, which is administered by the Bank of England, as their preferred RFR. The RFRWG is now focused on how to transition markets away from LIBOR to SONIA across sterling markets.

Since the beginning of the year regulators have been stepping up the pressure on market participants to transition away from IBORs, see our last note Turbo-charging the transition away from LIBOR.

ARRC Proposal

The vast majority of contracts involving LIBOR are either governed by New York or English law. The proposed New York State 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 harbour from litigation for the use of the recommended benchmark replacement.
• Specifically, the proposed legislation, on a mandatory basis, would:
• override existing fallback language that references a LIBOR-based rate and instead 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 would also, on a permissive basis, allow:
• parties with the right to exercise discretion or judgment regarding the fallback rate to avail themselves of the litigation safe harbour 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, the proposed legislation would not override existing contract language that specifies a non-LIBOR based rate as a fallback to LIBOR (e.g., the Prime rate).

Impact of the Legislation

This legislative proposal is a blunt tool which inevitably will create winners and losers upon the switch from US LIBOR. For securitisations basis risk, rather than being eliminated, may be created depending on the fallback language in: (i) the underlying assets, (ii) the notes issued by the securitisation vehicle and (iii) any derivative contracts entered into by the securitisation vehicles.

Additionally, parties losing out on the switch may still pursue litigation against their counterparties, for example, by seeking:

1. loopholes in the proposed safe harbours
2. to challenge the proposed new law under either the Contracts or Due Process clauses of the US Constitution
3.  if noteholders, to use §316(b) of the Trust Indenture Act 1939 (TIA), to argue that changes in the interest rate that impact the amount they receive are the sort of modification that requires unanimous consent under the TIA.

The proposed legislation rather than eliminating litigation on the cessation of US LIBOR may just change the nature of the litigation.

Effect on the transition of GBP LIBOR to SONIA

The ARRC announcement may have just cut the ground from underneath the Bank of England and FCA’s initiative to turbo-charge the transition away from GBP LIBOR to SONIA. Why spend time and effort transitioning if ultimately you believe the UK government will follow the lead of the United States and implement a legislative fix for LIBOR contracts governed by English law? The coronavirus has put on hold most market participants LIBOR transitioning initiatives.  As the number one priority now and in the coming months will be the preservation of their business, transitioning away from LIBOR is likely to take a back seat for market participants with calls already being heard for a delay to the 2021 cessation of LIBOR.

Any UK legislative fix is unlikely to eliminate litigation risk upon the cessation of LIBOR but instead will just shift the focus and nature of that litigation as parties negatively impacted by any legislation will seek to find redress through the courts.