Since the Financial Stability Board issued its report recommending reforms to interest rate benchmarks (including the London Interbank Offered Rate (LIBOR) in 2014), market participants have devoted considerable resources to prepare for LIBOR’s eventual cessation. The Federal Reserve Board and the New York Fed convened private industry participants to form the Alternative Reference Rates Committee (ARRC), a group that has been tasked with weaning U.S. markets off LIBOR after 2021. Based on model language formulated by ARRC, in April 2021, the New York State Legislature adopted new Section 18-C of the General Obligations Law, which provides a fallback following cessation of LIBOR for contracts governed by New York law that utilize LIBOR but lack a replacement benchmark. The new statute is a useful step, but there are questions as to its coverage, implementation and enforceability.
As recently summarized by the Financial Conduct Authority (FCA) of the United Kingdom, “the lack of an active underlying market makes LIBOR unsustainable, and unsuitable for the widespread reliance that had been placed upon it.” In July 2017, the FCA announced that it intended to stop persuading or compelling banks to submit rates for the calibration of LIBOR to the administrator of LIBOR after 2021. In March of this year, the FCA confirmed that all LIBOR settings currently published by ICE Benchmark Administration (IBA) will either cease to be provided by any administrator or no longer be representative:
- immediately after December 31, 2021, in the case of all sterling, euro, Swiss franc and Japanese yen settings, and the one-week and two-month U.S. dollar settings; and
- immediately after June 30, 2023, in the case of the remaining U.S. dollar settings.
The recent announcement by the FCA has increased the pressure on market participants that have relied on LIBOR to complete transition plans by the end of 2021.
In the United States, ARRC has played a critical role in organizing and supervising the transition away from LIBOR, providing guidance on best practices and proposing legislation providing for an automatic benchmark replacement rate. Among other things, ARRC has proposed the Secured Overnight Financing Rate (SOFR), published by the Federal Reserve Bank of New York, as an alternative to LIBOR for use in contracts that are currently indexed to U.S. dollar LIBOR, and has proposed a paced market transition plan to SOFR.
Any type of contract, security or instrument whose terms include rates based on or derived from LIBOR will be affected by the impending transition away from LIBOR-based rates. Certain instruments, however, provide less challenges than others. For example, the difficulty of the transition away from LIBOR for derivatives contracts has been more or less blunted by the ISDA IBOR Protocol. Commercial loans and credit facilities, which involve a relatively small number of lenders and are actively administered by an agent, are more readily amended, and many such facilities have already been modified to introduce a fallback mechanism. Even absent any amendment, these types of facilities typically allow borrowers to select from a list of alternative interest rate benchmarks, so that the facilities can continue to function even if LIBOR is unavailable. On the other hand, bonds and securitizations are often widely held and are difficult to amend, particularly with respect to interest rates. Instruments of this type, whose interest rates are LIBOR based but whose issuance predates the conversation on a transition away from LIBOR, present particularly vexing issues and have been referred to by the FCA as the “tough legacy” contracts.
In April 2021, the New York Legislature passed legislation, based on a model formulated by ARRC, to provide a fallback following the cessation of LIBOR for financial instruments governed by New York law that employ LIBOR but lack a replacement mechanism. The statute, which is codified as new Article 18-C of the New York General Obligations Law (GOL), is intended in particular to address the conundrum of the tough legacy contracts. Whether it does so successfully, however, is subject to question, as the statute itself seems to acknowledge.
A Summary of the New York Statute
The new statute is found in four sections, 18-400 to 18-403, of the NY GOL.
- Section 18-400 is comprised of 14 definitions, some of which have subsections and subclauses, that are utilized in the statute.
It is useful to cite a few defined terms at the outset.
“Benchmark” refers to “an index of interest rates or dividends rates that is used, in whole or in part, as the basis of or as a reference for calculating or determining any valuation, payment or other measurement under or in respect of a contract, security or instrument.” LIBOR of course is such a benchmark and is the focus of the statute.
“Benchmark replacement” means a benchmark “(which may or may not be based in whole or in part on a prior setting of LIBOR), to replace LIBOR or any interest rate or dividend rate based on LIBOR . . . .”
“Fallback provisions” mean “terms in a contract, security or instrument that set forth a methodology or procedure for determining a benchmark replacement . . . .”
- Section 18-401 legislates the effects of the discontinuance of LIBOR on covered agreements.
- Section 18-402, titled “Continuity of contract and safe harbor,” is a legislative proclamation as to the reasonableness the statute’s LIBOR replacement mechanism and an exculpation of liability for reliance on the statute. As discussed below, it appears intended to deflect certain challenges to the statute.
- Section 18-403 provides for severability of the statute, such that if the application of any of its provisions are deemed to be invalid to any person or circumstance, the invalidity does not affect the statute’s other provisions. This unusual statement is almost an acknowledgment that application of the statute may be legally infirm when applied to certain contracts, as addressed below.
The New York statute applies to contracts, securities and instruments whose terms:
- include interest rates or dividend rates determined by reference to U.S. dollar LIBOR; but
- do not contain a fallback provision or contain a fallback provision essentially relying on Libor.
Importantly, if a contract has its own LIBOR replacement mechanism, the statute will not apply.
The key operative provision of the New York statute states that –
“On the LIBOR replacement date, the recommended benchmark replacement shall, by operation of law, be the benchmark replacement for any contract, security or instrument [covered by the statute].”
The LIBOR replacement date is defined as either –
- the later of (i) the date of a public statement on behalf of the administrator of LIBOR or by certain other persons that the administrator of LIBOR has ceased or will cease to provide LIBOR and (ii) the date on which the administrator of LIBOR ceases to provide LIBOR; or
- a public statement by the regulatory supervisor for the administrator of LIBOR that LIBOR is no longer representative.
These events are referred to as “LIBOR discontinuance events.”
Recommended benchmark replacement is defined as a benchmark replacement based on SOFR, and includes any spread adjustments and conforming changes selected or recommended by the Federal Reserve Bank, the Federal Reserve Bank of New York or ARRC.
The statute also authorizes a “calculating person” to make other changes, alternations or modifications that in its reasonable judgment are necessary to permit the administration and calculation of the recommended benchmark replacement. Calculating person is defined with respect to a contract, security or instrument as a person “responsible for calculating or determining any valuation, payment or other measurement based on a benchmark.” This should include a calculation or similar agent under an indenture or other debt instrument — often the same person as the trustee — and gives this agent the authority to tailor the SOFR-based LIBOR replacement to the particular contract, security or instrument.
An alternative benchmark selected by a “determining person”
If there exists a “determining person” with respect to a contract, security or instrument, the statute permits the determining person to select a different LIBOR replacement in lieu of the SOFR-based recommended benchmark replacement. A determining person may select a LIBOR replacement at any time, without waiting for the LIBOR replacement date.
A determining person is defined as, among other things, a person with the “authority, right or obligation” to “calculate or determine a valuation, payment or other measurement based on a benchmark.” The definition is similar in this regard to the definition of calculating person, but is distinct in the discretion given to determining persons to select a replacement rate. Should it choose to exercise its authority under the statute, a determining person (should one exist under an indenture) would be empowered to choose an alternative to a SOFR-based rate as a replacement for LIBOR.
The New York statute is sensitive to the customary indenture provisions, typically referred to as being among the “sacred rights” of noteholders, which require unanimity to modify the interest rate under the indenture. For indentures qualified in the Trust Indenture Act of 1939 (TIA), section 316(b) of the TIA similarly provides that the right of a holder of an indenture security to receive a payment of principal and interest on the respective due dates expressed in the indenture cannot be impaired. Seemingly in order to blunt the effect of such provisions, the statute provides that the selection and/or implementation of a recommended benchmark replacement shall not constitute an amendment or modification of any contract, and shall be deemed to not “prejudice, impair or affect any person’s rights, interests or obligations under or in respect of any [contract].”
It remains to be seen whether legal objections to the statute will be lodged based upon the sacred rights of noteholders or the TIA, and if raised, how they will be dealt with in the courts. On the one hand, a New York statute purporting to override a provision of a previously executed indenture or the TIA, which is a federal statute, seems problematic. On the other hand, without modification, the indenture will be unworkable by its terms after the cessation of LIBOR.
What is meant by “based on SOFR”?
As noted above, the default replacement rate under the statute is a “benchmark replacement based on SOFR.” By its terms, the statute does not prescribe a specific substitute for a LIBOR-based interest rate formula. Rather it mandates that a replacement should be based on SOFR. The Federal Reserve publishes a variety of SOFR-based quantities. These include 30-, 90- and 180-day SOFR averages, and a SOFR index that can be used to calculate averages over custom periods of time. In contrast to LIBOR, which is a forward-looking rate benchmark, however, these averages are based on historical rates. ARRC is considering formulation of a forward-looking SOFR-based rate, referred to as Term SOFR, but has said that it is not currently in a position to recommend such a rate.
Presumably, a SOFR-based benchmark replacement should be one that most closely approximates the tenor of the LIBOR quantity that it is intended to replace, even if the match is imperfect. For example, a 90-day SOFR average might be used as a replacement for an interest rate based on three-month LIBOR. But simply porting over a corresponding SOFR quantity will be insufficient, and a number of adjustments may be necessary. The need for such adjustments is recognized by the New York statute, which includes in the “recommended benchmark replacement,” applicable by default, spread adjustments and conforming changes that may be promulgated by the Federal Reserve Bank, the Federal Reserve Bank of New York or ARRC. For example, ARRC is recommending a spread adjustment for translating between LIBOR and SOFR, using a methodology based on a historical median of the difference between the two quantities over a five-year lookback period.
Exercise of agent discretion
By authorizing calculating persons and determining persons to exercise discretion on the discontinuation of LIBOR, the New York statute provides for necessary flexibility in implementing a replacement benchmark in tough legacy contracts such as indentures. Discretion, however, is not something that a trustee or similar agent is wont to exercise in the absence of an event of default. A trustee by inaction can default to a SOFR-based LIBOR substitute, as prescribed by the statute. But even with a SOFR as the replacement, there will, as noted, be a need to translate to a particular SOFR-based quantity. There may also be a need for conforming modifications to an instrument that cannot be prescribed on a “one size fits all” basis by ARRC or the Fed, and that will require drafting tailored to a particular instrument.
Indenture trustees functioning as calculation agents will need to consider whether to make such modifications on their own, in conjunction with the issuer or with some form of noteholder support, even if this can only be obtained from less than all noteholders. Trustees will also have to decide on the form these modifications will take. Typically, indentures and like instruments are modified through a supplemental indenture, and a trustee is not required to enter into a supplemental indenture without an opinion of counsel. An unqualified legal opinion may be difficult to obtain where there is a modification of sacred rights, however. Trustees and their counsel will need to consider whether a reasoned opinion — one that is based on an analysis of the law and facts — will suffice in these unique circumstances.
Problems with fallback provisions
As noted, the New York statute does not apply to a contract, security or instrument that contains fallback provisions for determining a benchmark to replace LIBOR. The exclusion seemingly would apply even in circumstances in which as a practical matter it would be exceedingly difficult to implement the replacement benchmark. For example, the agreement governing a security might require a very high level of consent by holders — one that is unlikely to be achieved — in order to switch to an alternative benchmark. This could very well create a gap in the coverage of the statute.
The adoption of a replacement rate, whether by agreement of the parties to the contract or by operation of law as set forth in the New York statute, raises several income tax considerations. Perhaps most significantly, if such adoption were to give rise to a “significant modification” of a debt instrument, (i) it could cause holders to recognize gain or loss with respect to the debt instrument and (ii) if the debt instrument is trading at a discount at the time the replacement rate is adopted, it could cause holders to accrue original issue discount going forward and issuers to recognize cancellation of indebtedness income.
In October 2019, the Treasury Department and the Internal Revenue Service issued proposed regulations to address the federal income tax consequences of the transition away from LIBOR and other interbank offered rates (IBOR). In brief, Proposed Treasury Regulation Section 1.1001‑6 generally provides that if the terms of a debt instrument or non-debt contract are altered or modified to replace, or provide or alter a fallback to, an IBOR-referencing rate with a “qualified rate,” such alteration or modification (and any “associated” alterations or modifications, such as the addition of an obligation for a party to make a one-time payment to offset the change in value of a debt instrument resulting from replacement of the IBOR-referencing rate) will not result in recognition of income, gain, deduction or loss to any party thereto under Section 1001 of the Internal Revenue Code.
A qualified rate generally includes, but is not limited to, a rate based on SOFR, provided the fair market value of the debt instrument or non-debt contract after the alteration or modification is substantially equivalent to its fair market value prior thereto. In determining fair market value for this purpose, the parties may use any reasonable, consistently applied method, taking into account the value of any one-time payment as described above.
The New York statute only addresses contracts, securities and instruments governed by New York law. Although by convention New York law governs a substantial majority of indentures and credit facilities, if a financial agreement or instrument were governed by the law of another jurisdiction, the New York statute would be unavailing. Congress has begun consideration of federal legislation that would address the transition away from LIBOR, and which would apply irrespective of the governing law of an agreement or instrument or where the parties may be located. Also, unlike a state statute that might be attacked for inconsistency with the TIA’s provision on individual entitlement to payment of interest, a federal statute can simply override the TIA in this regard.
Finally, there is a question of timing. According to the FCA, U.S. LIBOR will not be discontinued until June 2023, giving parties responsible for tough legacy contracts such as indentures time to decide upon a course of action. It would appear advisable, however, not to wait until the actual discontinuation of LIBOR to take action on the transition. Documentation will likely need to be drafted to implement the transition, and various constituencies may need to be consulted, even as the New York statute provides the framework and legal underpinning for the required modifications. The time to act is relatively soon.
New Article 18-C of the New York General Obligation Law is the attempt of the New York Legislature to address by legislative fiat the serious problem of legacy financial instruments that employ LIBOR as a basis for their interest or dividend determinations, but have no provision for dealing with the termination of LIBOR in June 2023. The issue is particularly acute with respect to indentures and similar instruments that govern widely held securities requiring unanimity to alter their interest rate provisions. As the statute itself seems to recognize, it is not at all certain that it is possible to repair these securities through legislative action. The alternative, however, is either contractual paralysis or judicial intervention, so it is hoped that the legislative solution will hold. In all events, issuers and their trustees or other agents under these tough legacy contracts should begin to engage on these instruments, utilizing the framework provided by Article 18-C to address the transitional and drafting issues that are bound to arise.