President Joe Biden signed the Adjustable Interest Rate (LIBOR) Act into law on March 15, 2022, as part of a $1.5 trillion (about $4,600 per person in the US) omnibus spending bill. The LIBOR Act is a key piece of federal law, altering contractual terms for billions of dollars in existing financial transactions around the world and giving much-needed advice for borrowers, lenders, consumers, and investors navigating the imminent LIBOR discontinuation.
The London Inter-Bank Offered Rate (LIBOR) is a variable rate benchmark that is built on submission from a panel of banks expressing their estimated cost of borrowing. LIBOR was widely regarded as the “most liquid of floating-rate benchmarks,” with around $200 trillion (about $620,000 per person in the US) in outstanding dollar-denominated LIBOR-based financial instruments at their peak.
Following a series of scandals involving charges that banks manipulated the benchmark, LIBOR’s U.K.-based authorities declare in 2017 that the benchmark will no longer be published. LIBOR’s regulators confirmed on March 5th, 2021, that the publishing of LIBOR on a representative basis will stop for all tenors of USD LIBOR instantly after June 30, 2023.
Moving from LIBOR
Because of the amount and variety of USD LIBOR-denominated financial instruments, US financial firms and authorities have been wrestling with the demise of LIBOR for some time. In April 2018, the Federal Reserve Bank of New York began publishing the Secured Overnight Financing Rate (SOFR), which was chosen to replace LIBOR. On Nov. 30, 2020, federal banking regulators declared that financial firms should not engage in new contracts based on USD LIBOR after Dec. 31, 2021.
However, none of these solutions addressed how to move trillions of dollars in historical USD LIBOR transactions to a new benchmark. These transactions cover every asset type, which includes commercial loans, consumer loans, asset-backed securities, and financial market transactions such as derivatives. Many contracts involving legacy transactions lack provisions for the permanent discontinuation of LIBOR, are hard to change (securities that frequently need majority consent), or both.
The LIBOR Act
The LIBOR Act’s declared goal is to reduce confusion and minimize the economic impact of the discontinuation of LIBOR on existing USD LIBOR trades. President Biden signed the LIBOR Act on March 15, 2022, after it was passed by the House and Senate with bipartisan support.
The LIBOR Act is divided into five major components.
To begin, the LIBOR Act converts certain USD LIBOR-based agreements to a replacement rate automatically. The following USD LIBOR contracts are subject to automatic transition:
- Contracts with no “fallback provision” – that is, no terms for determining a benchmark replacement.
- Contracts that do not identify a specific non-LIBOR replacement rate (e.g., prime rate).
- Contracts that do not identify a “determining person.”
- Contracts that identify a determining person, but no replacement rate has been selected as of the LIBOR cessation date
As of July 1, 2023, the contract in each category will be transitioned to a statutory replacement rate under the Act (Reuters, 2022).
Secondly, the LIBOR Act repeals certain specific fallback provisions based on USD LIBOR, such as forcing a party to poll to determine LIBOR or requiring the replacement rate to be based on the most recent LIBOR screen rate. In practice, nullifying a LIBOR-based fallback provision means one of two things:
1. If the fallback provision includes a hierarchy of potential replacement rates (referred to as a “waterfall”), the parties continue to the next replacement rate option in the waterfall.
2. If the LIBOR-based replacement rate is the only or last replacement rate option permitted under the fallback provision, the contract is deemed to have no fallback provision and will automatically transit (Reuters, 2022).
Thirdly, the LIBOR Act offers a safe port in the event of a dispute emerging from the replacement of LIBOR. The Act shields parties from liability arising from the selection or use of a replacement rate provided that a statutory replacement rate is chosen to replace USD LIBOR. Furthermore, the safe port extends to contracts subject to automatic transition.
Fourthly, the LIBOR Act mandates that the statutory replacement rate be calculated using SOFR. Even though various versions of SOFR exist, the Terms SOFR and compounded SOFR, the Act ensures the Federal Reserve to issue a regulation which shows either version of SOFR that will pertain to contracts subject to the legislation, for example as asset-backed securities, business loans, consumer goods, and derivatives, within 180 days (about 6 months). The Act also mandates the Federal Reserve to update SOFR to compensate for LIBOR’s credit-risk adjustment and sets the spread adjustment for each tenor of LIBOR.
Lastly, the LIBOR Act provides the Federal Reserve to hold a regulation establishing technical or administrative changes that may be integrated into different contracts subject to the Act to support the implementation, management, and computation of the replacement benchmark, referred to as “conforming changes.” The Act also gives some contract parties the authority to make further conforming changes that are required or appropriate for replacing the benchmark. These conforming amendments become an “integral part” of the contract under the Act.
Considerations for the Future
Overall, the LIBOR Act offers a much-needed transition path for various and difficult-to-modify older contracts. Furthermore, by promoting a safe harbor, the Act empowers market participants with the capacity to pick a replacement rate for our SOFR. The Act, nonetheless, is not meant to be a major LIBOR transition strategy; federal financial regulators have said unequivocally that they want market participants to be proactive in resolving their LIBOR exposure.
The LIBOR Act also has limitations: USD LIBOR contracts that slip down to a particular non-LIBOR rate, such as Base Rate, Prime Rate, or Fed Funds, are not covered by the Act. Parties can under contractual terms agree to preclude their contract from the Act’s scope, and because of this, the safe harbor would not apply to contracts that choose a non-SOFR replacement rate. These are only a few instances of situations when the Act might not apply. In addition, several interpretive issues will need to be settled in the coming months.
Yet, the LIBOR Act is undeniably another key landmark for financial market players as they prepare for the end of LIBOR. Market participants should examine their LIBOR-based contracts to identify how the LIBOR Act affects their specific LIBOR exposure and how to depend on the Act to limit risk and enable a seamless transition away from LIBOR.
Information from Reuters