The LIBOR Sunset Series: Notes on the US LIBOR transition
The London interbank offered rate (“LIBOR”) for US Dollars, which forms the basis of the majority of US Dollar floating interest rate financial instruments, will commence being phased out at the end of 2021 and replaced with the Secured Overnight Financing Rate (“SOFR”). In the LIBOR Sunset Series, Freshfields’ finance experts answer frequently asked questions about the transition.
FAQ 1: Are legislatures going to solve the LIBOR transition problem?
As you may have read, in January, New York Governor Andrew Cuomo proposed legislation that would require interest rate provisions based on LIBOR to automatically “fall back” to SOFR. The proposed legislation is under review in the New York State Assembly, and it is likely to be approved and become effective in 2022. The proposed legislation was drafted by the Alternative Reference Rate Committee ( “ARRC”), the group organized by the Federal Reserve Bank of New York to identify an alternative reference rate to US Dollar LIBOR and provide guidance on the transition away from LIBOR. It was promoted by key finance industry groups and ARRC plans to pursue similar provisions in other jurisdictions.
It is important for CFO’s, treasurers and others working in treasury departments to understand what this proposed legislation achieves (and what it does not). Some assume the proposed legislation is a solution relieving borrowers and lenders from the inconvenience of amending existing debt documents for moving from LIBOR- to SOFR-based borrowings (call this the “magic wand” belief). Others are concerned that the proposed legislation imposes a one-size-fits-all requirement to transition to SOFR for existing debt agreements that will override loan parties’ preferences (call this the “big brother” concern).
Neither the magic wand belief nor the big brother concern is right. The actual scope of the legislation ARRC proposed – and that the New York legislature is currently considering -- is narrow and applies to a very limited universe of corporate debt arrangements. ARRC’s goal was only to transition certain legacy contracts that “do not have practical means to incorporate robust fallbacks”, often referred to as ‘tough legacy’ contracts because they do not include a ‘fall back’ rate and cannot be easily amended.
In particular, the following contracts fall outside the scope of the proposed legislation:
- Contracts that include a fallback to a non-LIBOR rate. Under the legislation, a fallback includes any method or procedure for determining a replacement rate. Nearly all US loan agreements provide a fallback to a base rate of interest pegged to prime or the federal funds rate when LIBOR is not available. As a result, the legislation will generally not apply to larger (and likely syndicated) US loan agreements.
- Contracts for non-US Dollar LIBOR. The legislation addresses a transition for US Dollar LIBOR only, and does not apply to contracts referencing LIBOR in any other currency. Therefore, this legislation will not conflict with regulations in other jurisdictions that may mandate certain transition rates and processes for Sterling, Euros or any other currency.
- Contracts not governed by New York law. The proposed legislation applies only to contracts governed by New York law. Even if adopted by other states or the U.S. Congress, legislative solutions will not apply to debt arrangements that reference LIBOR but are governed by the law of another state or foreign jurisdiction. Therefore, where US Dollar LIBOR is referenced in tough legacy contracts governed by a law other than New York law, alternative options to assist with the transition should be considered.
Indeed, the proposed legislation will be most useful in transitioning older securitization transactions that cannot be easily amended and smaller commercial contracts.
Unfortunately, nearly all larger corporate debt arrangements will be outside the legislative scope and active transition will be required. As a result, companies will still need to consider how to transition their companies’ debt arrangements from LIBOR to SOFR.
In further notes, we will explore in more detail how ARRC proposes that borrowers make this transition with their lenders, and help answer other thorny questions facing borrowers in getting to a post-LIBOR world.