The New York (NY) State Legislature has passed a statutory solution to tackle so-called “tough legacy” LIBOR contracts, to reduce the risks associated with the transition away from USD LIBOR: Senate Bill 297B/Assembly Bill 164B. This is very welcome news given the widespread use of NY law in financial contracts.
In this blog post, we continue to highlight the global progress of the legislative fixes in each of the key LIBOR jurisdictions (the UK, US and EU), consider the effect and scope of the NY legislation, look its safe harbour provisions in more detail and highlight the potential jurisdictional issues which may arise from the interaction between the different solutions.
The final form of the NY legislation is based on the draft proposal by the Alternative Reference Rates Committee, see our previous blog posts: LIBOR transition: What does the US regulator’s proposed legislative fix mean for UK financial markets? and LIBOR Transition: Is ARRC’s Proposed Legislative Fix Constitutional? Similar Federal level legislation seems to be a possibility as well.
LIBOR legislative solutions: global progress comparison
As regular readers of our updates will know, legislative solutions have been proposed in each of the key jurisdictions to convert legacy LIBOR contracts to a replacement benchmark, where the parties have been unable or unwilling to amend the contract and move to a new rate.
The EU’s legislation is already in force (see our blog post: Final EU legislative fix for legacy LIBOR: impact on transition risk for UK entities). The UK is yet to pass a statutory solution, although primary legislation to address “tough legacy” LIBOR contracts has been introduced to Parliament in the form of the Financial Services Bill (FS Bill) (see our blog post: LIBOR transition measures in the new Financial Services Bill: the legal framework, market impact and risks). Uncertainty in significant areas of that proposal remain, however.
New York has progressed its statutory fix notwithstanding the expected extension to end-June 2023 of the continued publication of certain USD LIBOR tenors (following the ICE Benchmark Administration Consultation on Potential Cessation published in December 2020). This makes the contrast with the position in the UK, where cessation of sterling LIBOR will take place at the end of this year, more stark.
Furthermore, even if the LIBOR provisions in the FS Bill are passed into law in their current form, parties will need to wait for the FCA to provide crucial clarity as to which contracts fall within the definition of “tough legacy” LIBOR and therefore within the scope of the legislative fix, as well as gaining important further clarity on what “synthetic LIBOR” will look like. The breadth of the definition of “tough legacy” will be considered as part of the FCA’s forthcoming consultation on its enhanced powers under the FS Bill (specifically its powers under Article 23C), which has not yet been published.
The UK’s delay in providing the market with confirmation as to the precise scope of its legislative solution is the source of significant frustration for participants. It is hoped that the good progress made in other jurisdictions will be followed closely by greater certainty in the UK.
Effect of the New York legislation
Turning to the effect of the NY legislative solution, any contracts caught within its scope will be transitioned automatically (“by operation of law”) from the relevant USD LIBOR rate to the “recommended benchmark replacement” rate. This is defined in the legislation as the appropriate adjusted SOFR plus a spread adjustment to be selected by the US regulators.
The trigger for transition has already been activated by the FCA’s announcement that all USD LIBOR settings will cease to be provided by any administrator or will no longer be representative immediately after 31 December 2021 (in the case of 1-week and 2-month USD settings) and immediately after 30 June 2023, in the case of the remaining USD settings (see our blog post: LIBOR Discontinuation: FCA non-representativeness announcement).
Parties have the right to opt out of the operation of the statute to instead switch to a reference rate of their own choice at any time (but this must be mutually agreed).
Scope of the New York solution
On its face, the NY legislation seeks to apply to USD LIBOR referencing “contracts, securities or instruments”, which is widely defined and likely to cover contracts relating to most financial products as well as general corporate/commercial contracts. The scope of the NY legislation is likely to be welcome, as it will capture the potentially vast numbers of non-financial contracts which use LIBOR in some way (such as late payment clauses). This is similar to the approach adopted in the EU and is to be contrasted with the likely scope of the UK legislative solution, where the focus (currently) remains on financial contracts only.
Having cast the net wide in respect of the types of contract to which it theoretically applies, the NY legislation controls which contracts will be caught by applying a filter based on the nature of the fallback. This is (again) similar to the EU mechanism and can be contrasted with the approach in the UK, where the FS Bill will apply based on the definition given to “tough legacy” (which the regulators have indicted will depend upon an ability/inability to actively transition).
To understand which contracts will in fact be caught by the NY legislation, it is critical to look at sections 18-401(1) and 18-401(2) (the mandatory provisions) and 18-401(3) (the discretionary provisions).
The first pillar of the legislation specifies the type of fallbacks that will result in the mandatory replacement of LIBOR, as follows:
- Where there is no fallback (18-401(1)(a));
- Where the fallback is itself based on LIBOR (18-401(1)(b));
- Where the fallback is based on a poll, survey, inquiries for quotes or information concerning interbank lending rates or any interest rate or dividend rate based on LIBOR. In this scenario, the effect of the legislation is that these fallbacks will be ignored, so that the contract will instead fall back to the next option in the waterfall. If, following the application of this provision, there are no remaining fallbacks, the contract will be deemed to contain no fallback (18-401(2)).
The second pillar of the legislation caters for contracts that give a party the right to exercise contractual discretion or judgment regarding the fallback (i.e. which do not specify a replacement rate but instead permit or require the determining party to select a benchmark replacement). In this scenario, the determining party is expressly given the option to exercise that discretion to select the “recommended benchmark replacement” under section 18-401(3).
Accordingly, the impact of the NY legislation solution on legacy USD LIBOR contracts will depend ultimately on the type of fallback used, which may lead to different results according to market type.
Take the example of a derivative contract where the parties have not adhered to the ISDA IBOR Fallbacks Protocol. Under both 1992 and 2002 ISDA incorporating the 2006 ISDA Definitions, the legacy fallback provisions require the calculation of an arithmetic mean of quotations which are obtained from certain specific Reference Banks, under what is described as the “dealer poll” method. This would appear to fall squarely within what is meant by a fallback being based on a poll, survey, or inquiry for quotes and so would seem likely to fall within section 18-401(2). On this basis, the NY legislation would apply to such USD LIBOR derivative contracts, subject to arguments based on the governing law of the contract (see forum shopping discussion below).
By way of further example, one could consider a typical waterfall in legacy standard LMA documentation, which could include an interpolated LIBOR rate, a historic LIBOR rate fallback (essentially, the last published LIBOR rate), a provision which is similar to the ISDA dealer poll method, and a “cost of funds” fallback. The interpolated LIBOR rate fallback and the historic LIBOR rate would arguably both fall within section 18-401(1)(b) because it is a rate based itself on LIBOR. The analysis in respect of the equivalent to a dealer poll method would be similar to that which would apply to the derivative contract considered above. Most interesting, perhaps, is the “cost of funds” fallback. It is not immediately obvious that this would fall within one of the categories contained in the NY legislation, given that it is based on the lender’s own cost of funding the loan in question. It therefore does not necessarily require a “poll, survey, inquiries for quotes or information concerning interbank lending rates”. Arguments may arise, however, as to whether the cost of funds calculation consists of “information concerning interbank lending rates”, perhaps depending on the source of the funds that a bank chooses to base its costs of funds calculation on.
While legacy USD LIBOR syndicated loans governed by NY law are more likely to be based on the standard documentation produced by the Loan Syndications and Trading Association (which did not contain a cost of funds fallback historically), there are many legacy USD LIBOR LMA-based and APLMA-based loans (often not governed by NY law), which would fall back to cost of funds. These legacy loan agreements may only fall under the NY legislation if cost of funds is interpreted as falling within one of the types of fallback at section 18-401 (again, subject to arguments based on the governing law of the contract).
Safe harbour and other key protections
The NY legislative solution is, like all of the legislative fixes which have been considered or introduced, inevitably somewhat of a blunt tool. It will change automatically the interest rate payable under any contract to which it applies when the relevant trigger is activated such that USD LIBOR is replaced by SOFR plus a spread adjustment. For those parties who lose out financially, there will be a real economic incentive to bring claims, and this could provide fertile ground for litigation.
However, the NY legislation provides for a package of safety nets, including express continuity of contract provisions, a broad form of safe harbour from potential litigation and a statement to guard against negative inference or negative presumption for contracts/events falling outside of the legislation:
- Continuity of contract. The NY legislation states that neither the discontinuation of USD LIBOR nor the selection/use of the “recommended benchmark replacement” (or related conforming changes) will affect the continuity of any contracts referencing LIBOR. This usefully means that the effect of the NY legislation cannot be relied upon as impacting contractual rights, to discharge or excuse performance, to terminate/suspend performance, to constitute a breach, or to void/nullify the contract in question.
- Safe harbour. The NY legislation includes a broad form of safe harbour from other claims for those whose contracts are switched to the “recommended benchmark replacement” (whether as a result of the mandatory or discretionary provisions of the legislation), which is intended to provide comfort to market participants in adopting that benchmark proactively and reduce the risk of speculative litigation following the transition event. The wording of the safe harbour from claims is broad and includes the following:
“…no person shall have any liability for damage to any person or be subject to any claim or request for equitable relief arising out of or related to the selection or use of [the recommended benchmark replacement]…and such selection or use of [the recommended benchmark replacement] shall not give rise to any claim or cause of action by any person in law or in equity.”
- No negative inference/presumption. The legislation also states that its provision should not be interpreted as creating any negative inference or negative presumption regarding the validity or enforceability of: (a) replacements for USD LIBOR that are not the “recommended benchmark replacement”; (b) other ways of calculating the spread adjustment; or (c) “any changes, alterations or modifications to or in respect of a contract, security or instrument that are not benchmark replacement confirming changes”.
By contrast, the EU’s legislative solution provides only for contractual continuity, with no express protection from civil claims. In the UK, the FS Bill does not currently contain a safe harbour, although HMT recently conducted a consultation to consider the case for including such provisions to reduce the potential risk of contractual uncertainty and disputes in respect of legacy LIBOR contracts that are caught by the mechanism (see our blog post: LIBOR transition: What is a “safe harbour” and why does the UK’s legislative toolkit need one?).
The outcome of HMT’s consultation is awaited, but it considered the inclusion of one or both of the following features in order to reduce such risks: (1) express wording as to the continuity of contracts that are automatically transitioned by the FS Bill; and/or (2) protection from claims relying on the effect of automatic transition under the FS Bill (e.g. a change in interest rate payable under the contract) as a cause of action, liability or grounds for litigation between parties to contracts. It is the second feature of the proposed UK safe harbour that may have the greatest impact on potential litigation and market disruption as a result of LIBOR transition. It raises the possibility of a broad immunity from the use of LIBOR (and then synthetic LIBOR), arising as a result of the operation of the FS Bill.
The inclusion in the NY legislation of an express provision to combat the potential for negative inference/presumption as a result of the legislation is interesting. One of the challenges for the market in relation to LIBOR transition is the risk of claims following active transition away from LIBOR. For example, if active transition leads to a customer being put in a position that ultimately turns out to be worse than if the same customer had been transitioned to an alternative rate (through the operation of the legislative fix or otherwise). This element of the NY legislation is designed to at least partially address this concern, and will arguably help to support active transition efforts, by seeking to avoid a presumption that active transition to any replacement rate other than the recommended replacement rate would give rise to the suggestion of invalidity or unenforceability.
Risk of forum shopping
The text of the NY legislation is not strictly confined to NY (or even US) law contracts. The only express relevant limitation on its scope is that it will apply only to contracts referencing USD LIBOR rates.
However, the legislation inserts the LIBOR transition law as a new section in New York’s General Obligation Law. Given that express choice of law clauses are generally recognised by NY courts (see N.Y. Gen. Oblig. Law § 5-1401), this could mean that the NY legislative solution will apply only to contracts containing an express choice of law clause in favour of NY law or, in the absence of such a clause, a strong connection to NY. If the jurisdictional reach of the NY legislative fix is limited to NY law contracts, then the fix is still likely to have wide application to a very substantial number of US and international contracts outside of NY, given the popularity of selecting NY law for commercial transactions.
It is possible that NY courts may apply the NY legislative solution even where the contract contains an express choice of law clause in favour of the law of another jurisdiction. Under rare circumstances, NY courts will disregard a foreign choice law clause where the application of the foreign law would offend a fundamental public policy of NY (see Welsbach Elec. Corp. v. MasTec N. Am., Inc., 7 N.Y.3d 624, 632 (2006)).
There is also a risk that other US states may decline to recognise a NY choice of law clause after applying their own choice of law analysis. For example, California could adopt similar LIBOR transition legislation but set a different replacement rate for certain types of consumer contracts. A California borrower could then argue that California courts should disregard NY law because California’s public policy interest in protecting California consumers outweighs NY’s interest in having NY choice of law provisions enforced.
By way of reminder of the approach taken in other jurisdictions, the FS Bill is not limited to contracts governed by UK law and purports to apply to all UK supervised entities (the extra-territorial effect of which is tempered by express requirements on the FCA to have regard to the likely effect outside of the UK when exercising its powers). However, the FS Bill is not limited to sterling LIBOR. The EU has taken a different approach, so that the EU solution will only apply to EU law contracts, unless the applicable law is of a third country which does not have its own legislative fix (and one of the parties to the contract is established in the EU).
The interaction between the different jurisdictional regimes has the potential for some very complicated issues of conflicts of laws, in relation to which it is too early to provide proper commentary. However, if a party stands to lose out financially, then there is a clear potential for forum shopping by that party to bring its claim in a jurisdiction where a more advantageous replacement rate applies or where the parameters of any safe harbour are different.