US lawmakers may be about to cut the Gordian knot of so-called tough legacy instruments tied up in the $200 trillion US dollar Libor transition, with a federal bill that has support from both sides of the political aisle.

The Adjustable Interest Rate (Libor) Act was passed by the House Financial Services Committee on July 29. If advanced by House and Senate votes, it will provide safe harbour under federal law for the toughest legacy contracts, including bonds and securitisations that otherwise have no safeguarded means of transitioning when US Libor is discontinued in June 2023. The bill will assure the fate of approximately $1.9 trillion in such contracts that are not covered by a similarly intentioned New York State law passed in April, and solve a critical piece of the US legacy puzzle for the obsolescent rate.

But not so fast. While the federal bill would cover contracts governed by US law, it leaves unaddressed huge swaths of US dollar Libor contracts covered by other jurisdictions – including those under English law, which governs a large slice of the estimated $74 trillion of outstanding exposures set to mature after Libor’s demise.

“At the moment, only New York law contracts are covered, which is pretty good for the bond market, and the federal legislation would sweep up more national issuance, such as the retail market, but from a cross-border perspective, that’s zero help,” says Davide Barzilai, partner at law firm Norton Rose Fulbright.

And while it would allow contracts under US law to become re-hitched to regulators’ preferred alternative rate, the secured overnight financing rate (SOFR), there is currently no safeguarded transition to any other Libor replacement rate – nor does the bill cover less-used one-week and two-month Libor settings which cease at the end of 2021.

Industry lawyers nonetheless welcome the benefits to those contracts within the scope of the new federal bill.

“The biggest concern with Libor has always been what we’re going to do with the notes that are already out there,” says Bradley Berman, counsel at Mayer Brown. “Consent solicitations won’t work, and people are concerned how much it’s going to cost and who’s going to sue. The New York legislation solved almost all of the problems and I think once the federal legislation passes, that’s pretty much going away.”

If passed, the federal bill will provide safe harbour for outstanding contracts under US law, which is to say the contracts will have legal protection to continue – in this case by switching to another rate, which in its current iteration means SOFR. It does this by relieving holders of the need to amend individual contracts or to poll investors for preferred fallbacks. And, crucially, it would pre-empt the so-called Trust Indenture Act (TIA), which was designed to protect holders of floating rate notes from being adversely impacted by contract alterations, and is a major obstacle to the state-level fix.

An amended version of the bill, passed by the House committee, puts major emphasis on the acceptance of alternatives to SOFR, the Federal Reserve’s preferred Libor replacement. Yet it’s still only SOFR-based successors that would be granted safe harbour from litigation and liability.

The biggest concern with Libor has always been what we’re going to do with the notes that are already out there

Bradley Berman, Mayer Brown

The additional language is understood to be a direct response to recent regulatory criticism of Bloomberg’s short-term bank yield index (BSBY) and other credit-sensitive rates. The amendment is seen by supporters of alternative rates as a step in the right direction, but one that may not go far enough.

“The language in the bill going to the floor before it goes to the Senate was helpful, but obviously still is viewed as putting BSBY and other credit-sensitive rates at a disadvantage. Some banks are hopeful that gets revised or strengthened as the legislative process continues,” says Bradley Ziff, operating partner with consultant SIA Partners.

The industry’s hopes of avoiding legal uncertainty in contracts governed by local laws in international financial centres rest on the UK Financial Conduct Authority’s (FCA) plans to create a so-called synthetic Libor substitute for tough legacy contracts. The implementation of this fix for Libor currencies that are being phased out at the end of 2021 is seen as a litmus test for a similar approach in the US. 

“We should see how synthetic Libor works in detail in the coming months, and it will be proved and tested in January 2022, when the rate is applied to sterling and other currencies,” says Barzilai. “That will be a prime test case for a US dollar version, but I have no doubt that it is needed.”

Not-so-solid state

Sponsored by Brad Sherman, the Democrat representative for California’s 30^th District, the federal bill is based on the earlier New York State law and addresses ‘broken contracts’ that have no fallback language, or are set to revert to unsuitable alternatives such as dealer polling or the last-available Libor rate.

The amended version passed by the House financial services committee on July 29 was approved by a voice vote of committee members – which bodes well for smooth congressional passage, say legal experts.

For the US, the legislation is deemed critical – the New York version is not only ineffective for contracts written under other state laws, but even overlooks many within its own jurisdiction.

“The need for federal legislation is super, super strong,” says a partner in the financial regulatory practice at a major US law firm. “The New York state legislation lacks the authority to pre-empt federal law.”

Lawyers fear contracts shunted off US Libor via New York legislation could still be fought out in the courts if parties are left out of pocket, limiting the state law’s utility. If a lending agreement currently specifies Libor as a fallback, for example, it might be economically preferable for a borrower to lock in the defunct rate rather than switch to SOFR via the legislative fix.

“The advantage of federal legislation is that it addresses contracts governed by all states, including New York, and it’s able to address head-on the fact that changes made to a contract are not going to be deemed changes that the Trust Indenture Act would prohibit,” says Emilio Jimenez, associate general counsel for JP Morgan. “New York state law cannot do that, because it cannot address the impact of federal laws like the Trust Indenture Act, but the federal statute can.”

New York law also fails to absorb corporate and retail contracts issued from other states. In the US, while the bulk of derivatives and floating rate notes are written under New York law, other instruments, such as preferred stock, are issued under the state of incorporation – often Delaware – while retail instruments, including mortgages, are issued under national laws.

Although designed primarily for the toughest legacy instruments, such as bonds and securitisations, the federal safety net would rescue US-governed contracts of all asset types – both cash and derivatives – and for entities of all stripes.

“It is designed to operate on the basis of contracts’ existing language to fix broken contracts, such as those that don’t have any fallback language or don’t have adequate fallback language, regardless of the nature of contract,” says Lary Stromfeld, partner at law firm Cadwalader, Wickersham & Taft. “The law applies to the language of contracts and tells you how to interpret that language under US law. It doesn’t apply at the entity level.”

A June survey conducted by SIA Partners of more than 30 firms, including banks, asset managers and corporates, found federal legislation was widely considered critical for structured finance and derivatives instruments, given the diverse array of lending statutes. Securitisations, for example, may be issued under New York law and incorporate an array of underlying loans governed by multiple state laws.

The federal remedy also avoids a patchwork of state-level fixes, which could deliver a variety of outcomes. In April, for example, Alabama followed New York with almost identical legislation, but it’s understood other state legislatures mulling similar action have now downed tools in response to strong bipartisan support for the bill.

SOFR under sufferance

One of the most intense debates surrounds the role of alternative rates. Many small and regional US banks dislike SOFR, due to its lack of credit-sensitivity. They worry loans linked to the rate could become unprofitable under stress scenarios, when risk-free rates diverge from bank funding levels.

Where a lender or administrator has discretion baked into legacy fallbacks, the legislation permits a choice of successor. Even so, the board-recommended replacement – defined as a SOFR-based rate – is the only one that would carry safe-harbour provisions. Contracts with no fallback language would automatically flip to the board-recommended replacement.

Many participants hope to see a choice of rates creep into the final bill, and some regulators seem to share their views.

Speaking at a July 14 House Financial Services Committee hearing, Federal Reserve chair Jerome Powell threw his support behind greater choice. “We need legislation for the hard tail. I think it would be appropriate to have SOFR in the legislation but not as an exclusive thing,” he said.

An amendment passed by the committee introduces a so-called ‘rule of construction’, stating the legislation would not “disfavour the use of any benchmark rate on a prospective basis”.

We are optimistic that the allowance of a credit-sensitive spread will be included in the final legislation

Erik Rust, Bank Policy Institute

Although not an operative provision of law, SOFR sceptics cast the development as a significant win in the light of rising regulatory ire over credit-sensitive rates. At a June meeting of the Financial Stability Oversight Council (FSOC), Securities and Exchange Commission chair Gary Gensler stressed concerns around rising use of BSBY, saying it suffered from “many of the same flaws as Libor”. The following month, the UK’s FCA issued a similar warning and called for regulated UK firms to ask their supervisors before using such rates.

“The larger banks want the federal legislation because they’ve got legal agreements in a number of jurisdictions and appreciate the limits to what the New York legislation can do. The reason the smaller, regional banks are focused on the outcome of this legislation is that SOFR is given preferential treatment versus credit-sensitive rates [CSRs] for fallback language purposes and legal certainty,” says SIA’s Ziff.

“If that can be altered, and CSRs such as BSBY or Ameribor are not excluded from that consideration, then there is a better chance of success when that product is offered to their clients in the near future.”

There is still hope for further amendments as the legislation passes. Rather than SOFR alternatives, some are pinning their hopes on a middle-ground option, which would permit a credit-sensitive spread to be layered over SOFR.

“We are optimistic that the allowance of a credit-sensitive spread will be included in the final legislation,” says Erik Rust, vice-president of government affairs at the Bank Policy Institute. “Credit-sensitive rates allow banks the flexibility to hedge against credit risk and rising funding costs.”

Synthetic space

But none of this addresses the question of those contracts not covered by US federal legislation.

Many European borrowers issue US dollar bonds and loans under English law and in Asia, US dollar loans are commonly issued under local laws, including Australia, Hong Kong and Singapore.  

“If you are a Hong Kong investor with a New York bond, it is going to be effective, but when it comes to English law and other governing law contracts, the US legislation is of no value there,” says Barzilai. “It’s where the synthetic Libor rate from the FCA will come in, and that’s really where it’s needed.”

Synthetic Libor is being crafted by the UK’s FCA as a tough legacy remedy for sterling and yen markets. The formula-based rate, comprising a term version of the relevant risk-free rate plus the same spread adjustment calculated by fallbacks devised by the International Swaps and Derivatives Association, would take Libor’s place on relevant screens – typically Reuters Libor01 – and be available for use in legacy contracts on Libor’s discontinuation.

Edwin Schooling Latter, director of markets and wholesale policy at the FCA, also flagged the possibility of a US dollar version at an industry event in April.

“We might in due course propose publication of a synthetic US dollar Libor rate at one-, three- and six-month tenors to provide time-limited relief for legacy contracts, but it’s too early to say if this will be necessary or feasible,” he said.

He added that certain conditions would need to be met, including “appropriate inputs” – namely a term SOFR rate. On this point, the stars may be aligned: on July 29, the Alternative Reference Rates Committee endorsed a term SOFR published by CME.

FCA proposals would currently deem a synthetic Libor rate ‘non-representative’ under UK Benchmark Regulation, and therefore unavailable for new contracts. Its use could also be outlawed in some legacy contracts. The FCA is consulting on whether to prohibit the safety net for outstanding derivatives.

Yet the regulator’s power to curb use extends only to UK firms under its jurisdiction. US and other non-regulated entities could potentially use such rates more widely.

Others worry a synthetic Libor could leave the door ajar for litigation. Many contracts simply link interest payments to a rate published on trader screens, such as Reuters’ Libor01. This means they should track whatever number is published, irrespective of how it is calculated. Yet some contracts are more prescriptive.

“In many cases, the definition is the relevant Reuters page, or any successor page for the purpose of quoting interbank lending rates. If you come up with synthetic Libor that’s not based on London interbank lending rates, it won’t be picked up by the defined terms. The definitions built into many medium-term note programmes would eliminate something that appears on Reuters Libor01 if it’s not an interbank lending rate,” says Mayer Brown’s Berman.

Barzilai says legal complications around the use of synthetic Libor are unlikely. “It would depend what’s actually written in your contracts and whether it’s loosely worded or very specific, but generally, on standard wording, we shouldn’t have any discussion around that.”

Nonetheless, in a belt and braces approach, the UK is planning to introduce safe harbour provisions, similar to those proposed in the US, aimed at ensuring legal certainty for English law contracts that flip to synthetic Libor. The working group on sterling risk-free rates raised this in an April letter to the UK Treasury.

The Treasury responded in May, saying the government would introduce legislation to deal with this when parliamentary time allows.

Prime time

There are other concerns with a US legislative approach – inadequate fallbacks are defined as those that have some reference to Libor, whether by dealer polling or last available rate; any contracts slated to switch to an existing rate would continue to do so, regardless of any economic impact.

Legacy loans originated prior to the development of regulator-approved fallback language, which has been hardwired into most contracts issued since 2019, are largely set to re-hitch to the prime rate. This is an average of the rate commercial banks charge to their most creditworthy corporate clients, which was quoted at 3.25% in mid-August. This compared to 0.12% for three-month dollar Libor, meaning borrowers could find themselves out of pocket.

The law is only meant to fix broken contracts, not contracts that are clear on what happens

Lary Stromfeld, Cadwalader, Wickersham & Taft

“If the contract is clear that when Libor goes away the contract will move to prime or Fed funds, then the law does not touch that. It may end up being a significant economic change, but if the contract is clear and that’s what was agreed to, it will apply,” says CWT’s Stromfeld. “The law is only meant to fix broken contracts, not contracts that are clear on what happens.”

The Fixed Income, Currencies and Commodities Markets Standards Board (FMSB) warned in April that many legacy fallbacks were designed to deal with a temporary rather than permanent cessation of Libor. “Seeking to rely on existing fallback language may be commercially inappropriate in the event of full cessation, particularly in circumstances where the resulting interest rate paid by the corporate would be materially higher,” the industry group warned in a report on conduct risk.

While prime is a common fallback in legacy lending agreements, some lenders say the problem should largely be swept away, given US Libor’s extended cessation date.  

“The legislation is not meant to step in to replace something that’s been contractually agreed. While the prime rate is common in a lot of US-based loan agreements, through negotiation that would transition across,” says a loans head at a European bank.

“When you haven’t got either hybrid or hardwired fallback language, those are the contracts that need to be addressed before June 2023 to avoid that scenario.”

Editing by Louise Marshall