The cessation of the London Inter-bank Offered Rate (LIBOR) at the end of 2021 has long been an issue vexing the global financial services industry given the scale and geographic spread of exposures to the affected benchmarks across the currencies and terms in which it is published. As we reach what Andrew Bailey, Governor of the Bank of England, has called the “endgame”, we thought it would be useful to publish an update on the status of this transition. In our LIBOR Transition Status Update – October 2020, we draw together key recent developments in this transition and summarise the current status in the most impacted product markets at this critical juncture. Continue reading
The European Commission has published its proposals for an EU legislative solution for the transition of legacy LIBOR contracts.
This announcement follows hot on the heels of recent announcements for similar legislative fixes in the UK (read our blog post: UK Government announces LIBOR legislative fix: summary of proposals and our initial observations) and the US (read our blog post: LIBOR transition: What does the US regulator’s proposed legislative fix mean for UK financial markets?).
In this blog post, we provide an overview of the Commission’s proposals; compare the legislative solutions from the UK, US and EU; and comment on the effect this EU law development is likely to have on LIBOR transition risk. Continue reading
In a written statement on 23 June 2020 made by Rishi Sunak, The Chancellor of the Exchequer, the UK Government has announced its intention to introduce a legislative solution for the transition of so-called “tough legacy” LIBOR-linked products. Continue reading
The latest development in the Bank of England’s (BoE) attempts to support the adoption of SONIA in cash products – and to speed up the transition away from LIBOR-linked products – is the publication of its response to the consultation it conducted into the publication of a SONIA index: Supporting Risk-Free Rate transition through the provision of compounded SONIA: summary and response to market feedback (June 2020). Continue reading
The FCA and PRA yesterday published a joint statement setting out their key observations from the responses of major banks and insurers in the UK to the Dear CEO letters published in September 2018, which asked for details of the preparations and actions being taken by those firms to manage transition from LIBOR to alternative interest rate benchmarks (SONIA in the UK).
The statement confirms that the FCA and PRA have reviewed responses from those firms and provided feedback directly. In addition, given the market-wide nature of the issue, they have decided to publish a number of market-wide observations which they have made in the course of reviewing the responses to the Dear CEO letters. The FCA and PRA identify a number of critical elements which were present in “stronger responses” to the Dear CEO letters, which are summarised below and provide some helpful guidance for other firms affected by LIBOR discontinuation.
As repeatedly emphasised by the FCA and PRA, given the widespread use of and reliance on LIBOR, there are significant risks associated with transitioning from LIBOR to alternative risk free rates. We considered in some detail the potential litigation risks in our article published in the Journal of International Banking Law and Regulation: LIBOR is being overtaken: Will it be a car crash? (2019) 34 J.I.B.L.R..
The stated purpose of the Dear CEO letter was to seek assurance that firms’ senior managers and relevant governance committee(s) understand the risks and are taking appropriate action now. It is clear from the joint statement that there is real divergence across the market in terms of preparedness for LIBOR discontinuation. This latest communication is a further call to action from the FCA and PRA to ensure firms are properly prepared for the transition.
Good practice identified by the FCA and PRA for LIBOR transition
- Identifying reliance on and use of LIBOR beyond a firm’s balance sheet exposure and assessing (for example) whether LIBOR is present in the pricing, valuation, risk management and booking infrastructure firms use.
- Quantification of LIBOR exposures using a range of quantitative and qualitative tools and metrics, keeping the metrics up to date.
- Nominating a senior executive covered by the Senior Manager Regime as the responsible executive for transition, with clarity on the senior manager’s role in transition work.
- Developing a project plan for transition with sufficient granularity of detail, including key milestones and deadlines to ensure delivery by end-2021.
- Carrying out a detailed prudential risk assessment (subject to appropriate review and challenge), taking a broad view and considering all risks that could be relevant to a firm’s operations. Aligning identified risks with appropriate mitigating actions.
- Identifying a range of conduct risks, including management of potential asymmetries of information and the potential for conflicts of interest, when forming and reviewing transition plans. Again, aligning identified risks with appropriate mitigating actions.
- Planning and managing risks on the basis of LIBOR discontinuation at the end of 2021, rather than assuming that it will continue in some form thereafter.
- Demonstrating a good understanding of and involvement in with relevant industry initiatives.
- Proactively transacting using new risk free rates or taking steps to incorporate robust fallback language.
In a speech given on the same date this feedback was published, Dave Ramsden (Deputy Governor for Markets and Banking at the Bank of England) made clear that regulatory scrutiny in relation to LIBOR transition will continue:
“More generally, I only see the level of supervisory engagement on this topic intensifying to make sure firms are ready for end 2021. The response to the Dear CEO letter provides a basis for this engagement to continue.”
Firms (whether recipient of the original Dear CEO letter or not) should therefore reflect carefully on the published feedback. No doubt it will also be of interest to firms considering benchmark transition issues in other jurisdictions, notably in Hong Kong and Australia where the regulators have similarly asked firms to confirm their preparedness.
We commented last month on the announcement from the International Swaps and Derivatives Association (ISDA), confirming the preliminary results of its re-consultation on the implementation of pre-cessation fallbacks for derivatives referenced to LIBOR: ISDA pre-cessation fallback consensus: will this reduce legacy LIBOR risk in the derivatives market?
ISDA has now published a report summarising the responses received from the industry to the consultation, and it makes for very interesting reading.
The report explains that 91% of respondents were in favour of combining pre-cessation and permanent cessation fallbacks without optionality or flexibility, in the amended 2006 ISDA Definitions for LIBOR and a single protocol. A common reason given by market participants was the need to achieve consistency across asset classes (generally between cash and derivative markets) and between cleared and non-cleared derivative markets.
However, although the scale of consensus may at first appear overwhelming, a more detailed reading of the report reveals how delicate that consensus might be. For example, several market participants who were in favour of the pre-cessation trigger indicated that their response was conditional on achieving actual consistency; and some who were not in favour of including the pre-cessation trigger also cited consistency as their main reason (e.g. being more preferable for there to be consistency within an asset class, i.e. non-cleared derivatives, than between asset classes).
It is unsurprising that the desire for consistency from the market is the driving force behind industry views on pre-cessation triggers. Indeed, we have discussed in our previous blog posts that basis risk creating mismatches between different parts of a party’s portfolio, and the impact of a single fallback with no optionality on protocol adherence, were likely to be key factors for market participants.
The upshot is that many respondents who would agree on the importance of consistency as a high level principle have still answered differently in response to the consultation, in part because of slightly different perspectives on how the ISDA consultation fits in with wider industry efforts (which are ongoing). Despite this fact, ISDA has confirmed that it expects to move forward on the basis of both permanent and pre-cessation triggers in the amended definitions and a single protocol. Attention will no doubt turn to the impact of this result on the efforts in other markets, and whether some measure of consistency with the derivative markets can be achieved.
In early March, 2020, the Alternative Reference Rates Committee (ARRC) in the US published a proposal for New York legislation to assist the transition of financial contracts away from US dollar (USD) LIBOR. In a blog post in March, HSF provided an overview of this proposal and its specific provisions. LIBOR transition: What does the US regulator’s proposed legislative fix mean for UK financial markets? In this blog post we will discuss potential constitutional objections to ARRC’s proposed legislative fix, and discuss the viability of such arguments in US courts.
If New York enacts the legislation as proposed, certain provisions that retroactively affect the terms of existing contracts could be struck down if New York state or federal courts determine that they violate the US Constitution. Two constitutional provisions, the Contract Clause of Article 1 and the Due Process Clause of the Fourteenth Amendment, provide a potential basis to challenge the validity of state legislation which imposes retroactive effects on existing contracts. The likelihood of success or failure of such a challenge to the proposed legislation would depend on a number of factors, discussed below.
1. Overview of Retroactive Provisions in ARRC’s Proposed Legislation
There are several key provisions in ARRC’s proposed legislative fix that would affect existing contracts whose terms reference LIBOR-linked rates. These provisions include:
- Any contracts that do not contain fallback language or fall back to a LIBOR-linked rate will automatically transition from LIBOR to the “recommended benchmark replacement” (e., the Secured Overnight Financing Rate (SOFR) plus a spread adjustment, both of which will be selected by the US regulators).
- On April 8, the ARRC recommended a spread adjustment based on a historical median over a five-year lookback period calculating the difference between USD LIBOR and SOFR.
- Any legacy language that includes a fallback to polling for LIBOR or other interbank funding rate will effectively be ignored.
- Providing a safe harbor from litigation for using the recommended benchmark replacement.
- The discontinuation of LIBOR will not affect the continuity of any contracts referencing LIBOR, e., it cannot be relied upon to discharge or excuse performance of the contract in question.
As a general principle of statutory construction in both federal and New York State courts, there is a presumption against interpreting laws to have retroactive effects. This presumption does not apply, however, where the legislative language and history shows a clear intent to have retroactive effects. ARRC’s proposed legislation will clearly have a retroactive effect on contracts, as it must in order to achieve ARRC’s stated goals of guaranteeing continuity of contracts and preventing uncertainty, harm to consumers, and unnecessary litigation.
2. Potential Impact of the ARRC’s Proposed Legislation on Existing Contracts
Central to any constitutional challenge to retroactive legislation will be the degree of harm or impairment on contracts caused. The scope of the legislation is extremely wide: LIBOR is used as a financial benchmark linked to more than US $350 trillion in financial instruments, a significant percentage of which are governed by New York law. Although the ARRC is attempting to create a replacement rate methodology designed to account for the differences between SOFR and LIBOR, such a rate will never be able to perfectly match LIBOR under all market conditions. The lack of credit risk being priced into overnight rates such as SOFR means that, even with a spread adjustment, the replacement rate will not respond to credit conditions in the same way that LIBOR would. This pricing differential between the replacement rate and LIBOR, whether it is higher or lower, will inevitably create winners and losers. As the LIBOR scandal demonstrated, a change of even a small number of basis points in multibillion dollar interest rate swaps can potentially amount to millions of dollars in profits or losses to a party.
Some of the potential impacts from the replacement rate set by the proposed legislation could include:
- A replacement rate that is set higher than LIBOR could hurt borrowers. A higher rate could negatively impact consumer loans and increase the risk of defaults and foreclosures for vulnerable consumers.
- A replacement rate that is set lower than LIBOR could lower the profitability of loans for lenders. This could fundamentally change the profitability of certain contracts and upset the expectations of parties that relied on them.
- The limited accounting for credit risk in SOFR could expose certain contracting parties to a potentially greater level of risk than they had negotiated.
Regardless of the pricing differential between LIBOR and the replacement rate that is ultimately used, the proposed legislation may cause other effects on contracting parties, including:
- Increased compliance costs associated with the transition to a new rate and implementing the required changes.
- Increased risk of regulatory enforcement for financial institutions that fail to transition to the recommended rate or apply a rate using an incorrect methodology.
- Increased costs associated with renegotiation of contracts.
3. Overview of the Contract’s Clause’s Blaisdell Test
The Contract Clause of the US Constitution states that “[n]o State shall . . . pass any . . . Law impairing the Obligation of Contracts.” In Home Building & Loan Association v. Blaisdell, 290 U.S. 398 (1934), the Supreme Court adopted its current approach to the Contract Clause, which balances the Contract Clause’s prohibition of contract impairments against countervailing state interests. Under the “Blaisdell test,” the Contract Clause invalidates any state law which constitutes a “substantial impairment” of a contractual relationship unless the law satisfies certain conditions. If a state law does impose a substantial impairment, the law must (a) advance a “legitimate public purpose” and (b) be appropriately tailored to serve that purpose.
The proposed ARRC legislative fix has some precedents, and it is partly based on earlier “continuity of contracts” legislation enacted by New York in 1998 to address the discontinuance of national currencies then-scheduled to be replaced by the euro (Illinois, California and several other US states enacted similar legislation). That legislation, which had similar retroactive effects on existing contracts denominated in certain national currencies, was not formally challenged on constitutional grounds in a US court. Unlike the conversion of a discontinued national currency to the euro, however, ARRC’s proposal to replace LIBOR with a fundamentally different overnight rate like SOFR could potentially result in a greater change to the value of a contract.
a. Does the ARRC’s Proposed Legislation Constitute a “Substantial Impairment” on Existing Contracts?
The first inquiry under the Blaisdell test is whether the state law at issue imposes a “substantial impairment” on an existing contractual relationship. A state law which has no effect or only a minimal effect on a contract will not violate the Contract Clause, regardless of its purpose. The Supreme Court recently applied the Blaisdell test in upholding a Minnesota statute (which automatically removed an ex-spouse as an insurance beneficiary following divorce) because they determined that the statute did not constitute a substantial impairment. Sveen v. Melin, 138 S. Ct. 1815 (2018). The Sveen decision identified several relevant factors in determining that there was no substantial impairment: the statute was intended to further a “typical” insurance policyholder’s intent, the statute was unlikely to upset the policyholder’s reasonable expectations, and the policyholder could reinstate the ex-spouse with a simple form. In another Contract Clause case, Energy Reserves Grp., Inc. v. Kansas Power & Light Co., 459 U.S. 400 (1983), the Supreme Court held that a state legislative intervention to place price limits on existing natural gas contracts following federal price deregulation was not a substantial impairment where all parties entering into such contracts had expected regulated prices.
At this stage, it is difficult to determine whether the ARRC’s proposed legislation would rise to the level of substantial impairment before the terms are finalized and the degree of harm to a party becomes clear. The proposal does contain several measures which are ostensibly designed to honor the expectations and intent of the contracting parties by attempting to provide an alternative to LIBOR. The proposed legislation includes a “spread adjustment” in order to reflect the difference between LIBOR and SOFR to which contracts will transition. Despite this spread adjustment, however, the ultimate rate used will not match LIBOR exactly and the difference could disadvantage a contracting party, perhaps substantially. The availability of an opt-out provision, which was cited as weighing against substantial impairment in Sveen, will have more limited significance for existing contracts where two or more parties with conflicting interests must mutually consent to opt-out.
b. Does the Proposed Legislative Fix Have a “Legitimate Public Purpose”?
State laws which are found to impose a substantial impairment on one of the contracting parties must serve a “legitimate public purpose.” The Supreme Court has recognized the need to allow states to sometimes impair contracts in order to exercise legitimate police powers, rather than benefitting a legislatively favored special interest. Courts will generally defer to a state legislature’s judgment to determine whether a law serves a legitimate public purpose (unless the state itself is a party to the contract affected).
Legislation that aims to remedy a “broad and general social or economic problem” will meet this standard, while legislation that provides a benefit to special interests will not. Energy Reserves Group, Inc. v. Kansas Power & Light Co., 459 U.S. 400, 411 (1983) The Supreme Court has found a legitimate public purpose in legislation aimed at preventing increased litigation and uncertainty surrounding land titles, City of El Paso v. Simmons, 379 U.S. 497 (1965), and in legislation intended to address and control “serious economic dislocations.” Kansas Power & Light Co., 459 U.S. at 409.
Based on previous Supreme Court decisions, ARRC’s proposed legislation likely satisfies the requirement for a legitimate public purpose. ARRC’s proposal outlines an ominous litany of potential negative that could result if legislation is not enacted, including: increased litigation between parties, uncertainty for mortgages, student loans and borrowers, credit rating downgrades, and “extreme volatility.” Although this is no doubt in part to provide New York lawmakers with a political rationale to enact the legislation, it also articulates a number of legitimate public purposes that could be cited to support the legislation’s validity in a Contract Clause challenge.
c. Is ARRC’s Proposed Legislative Fix Appropriately Tailored?
If a state law is found to have a legitimate public purpose, any adjustment of the rights and responsibilities of contracting parties still must be based upon “reasonable conditions” and be “of a character appropriate to the public purpose” which justified its adoption. Keystone Bituminous Coal Ass’n v. DeBenedictis, 480 U.S. 470, 505 (1987). The Supreme Court has noted that this is not a significant burden to overcome and that courts should generally defer to legislative judgment on the reasonableness or necessity of a particular measure. Id.
If the ARRC’s proposed legislation is found to have a legitimate public purpose that justifies a substantial impairment of contracts, the measures it proposes to achieve that purpose should be able to satisfy this test. It is difficult to conceive how the legislative fix could guarantee the continuity of contracts or prevent uncertainty and unnecessary litigation without mandating an automatic transition away from LIBOR. The proposed legislation includes several measures designed to minimize the level of disruption for existing contracts to the extent that it is possible while still achieving its goals. These measures include delaying the mandatory transition to the recommended replacement rate until LIBOR is discontinued, including provisions for parties to opt-out, and providing for a spread adjustment. Still, the implementation of a particular measure by a regulatory agency could potentially run afoul of the Contract Clause (a regulation is considered a state law for Contract Clause purposes).
4. The Proposed Legislative Fix Raises Minimal Due Process Clause Concerns
The Due Process Clause of the Fourteenth Amendment prohibits states from “depriv[ing] any person of life, liberty, or property, without due process of law.” The Supreme Court has held that the Due Process Clause can prohibit retroactive state laws under limited circumstances where the consequences are particularly “harsh and oppressive.” U.S. Tr. Co. of New York v. New Jersey, 431 U.S. 1, 17 (1977). The level of scrutiny imposed by the Due Process Clause on retrospective legislation is, however, much lower than the scrutiny required by the Blaisdell test. For economic legislation such as the ARRC’s proposed legislative fix, a state law is subject only to “rational basis” scrutiny; the law only needs to have a “legitimate legislative purpose furthered by rational means.” General Motors Corp v. Romein, 503 U.S. 181, 190 (1992). The New York State Constitution also contains a due process clause that would apply to retrospective New York state legislation, but this due process clause has similar terms and is generally coextensive with the Fourteenth Amendment’s due process requirements. N.Y. CONST. art I, § 6.
If the legislation meets the stricter Blaisdell test required by the Contract Clause, then it will very likely satisfy the more lenient rational basis test required by the Due Process Clause.
5. Key Takeaways
Given the large number of existing contracts that will be affected by ARRC’s proposed legislation and the potential scale of the impact (ARRC estimates the value of these contracts to be around $2.5 trillion in value), aggrieved parties may seek to invalidate retroactive provisions of the legislation on Contract Clause grounds. In order to prevail in such a challenge, a party would need to show that the relevant provision did not satisfy the elements of the Blaisdell test. First, a party would need to show that the legislation substantially impaired a contractual relationship. After substantial impairment is established, the party would then need to show there was either no legitimate public purpose or that the legislation was not appropriately tailored to serve an otherwise legitimate public purpose.
Such a challenge may be difficult under existing Contract Clause case law—the measures proposed by ARRC appear relatively modest when compared with state laws that have been upheld in previous cases, and courts will generally show deference to state legislatures in economic matters. Still, open questions remain that could make a Contract Clause challenge more viable. The draft legislation has not yet been introduced into the New York state legislature and it may still be amended or implemented in a way that creates a more onerous or unreasonable burden on existing contractual relationships. The legislation will be at greater risk of a challenge if it alters contracts more than is necessary to address LIBOR discontinuation concerns—particularly if this is done to benefit a legislatively favored group.
The Working Group on Sterling Risk-Free Reference Rates (RFRWG) has published a further statement on the impact of COVID-19 for firms’ LIBOR transition plans.
The latest statement follows the earlier joint statement made by the FCA, Bank of England and RFRWG on 25 March 2020, in which the regulators set out their initial response to the impact of COVID-19 on transition plans.
In this blog post we consider the specific delays to interim LIBOR transition milestones that have been announced, the likely effect such delay is likely to have on loan market LIBOR transition and how this may impact the profile of the associated litigation risks.
Overarching theme of the regulators’ COVID-19 impact statements
Both of the statements published by the regulators/working group, emphasise that the deadline for LIBOR cessation remains fixed for end-2021 and firms cannot rely on LIBOR being published after that date, notwithstanding the impact of COVID-19 on firms’ steps to prepare for that event. The regulators are working with the RFRWG and its sub-groups and task forces to consider how all firms’ LIBOR transition plans may be impacted.
However, recognising the reality at least in the short term, it is clear that some interim transition milestones may be delayed. The most recent communication announces the first key date to be affected.
Delay to key interim milestone in the loan market
The first key interim LIBOR transition milestone to be affected by COVID-19 is the deadline by which the cash market is recommended to stop issuing LIBOR linked loans. That deadline was originally the end of Q3 2020 but has now been pushed back to the end of Q1 2021.
The RFRWG’s current timetable as to the use of LIBOR-linked loan products is now as follows:
- By the end of Q3 2020 lenders should be in a position to offer non-LIBOR linked products to their customers;
- After the end of Q3 2020 lenders, working with their borrowers, should include clear contractual arrangements in all new and re-financed LIBOR-referencing loan products to facilitate conversion ahead of end-2021, through pre-agreed conversion terms or an agreed process for renegotiation, to SONIA or other alternatives; and
- All new issuance of sterling LIBOR-referencing loan products that expire after the end of 2021 should cease by the end of Q1 2021.
The regulators have repeatedly acknowledged that the loan market has made less progress in transitioning away from LIBOR than other markets. This led to various initiatives earlier this year to accelerate change, with an emphasis on steps to alleviate some of the difficulties which were faced in the cash markets: The Bank of England’s attempts to “turbo-charge” LIBOR transition in the cash markets: will these increase or decrease the litigation risks? In particular, the Bank of England announced the publication of a SONIA-linked index from July 2020 to support market participants to cease issuing LIBOR-based cash products (maturing beyond 2021). It is therefore perhaps not surprising that the first interim milestone to be relaxed is in that market.
Impact on loan market LIBOR transition
Given that one of the most important drivers to move the cash market to new risk free rates (RFRs) is to stop writing new loans linked to LIBOR, the RFRWG’s decision to delay this particular milestone is significant, though not surprising given the pressures that both lenders and corporates find themselves under as a result of COVID-19.
While there was significant impetus from both lenders and corporates behind a movement to RFRs in the loan markets in Q1 of 2020 (for example British American Tobacco signed a USD 6bn revolving credit facility linked to both SONIA and SOFR in March – see this press release), which will be further boosted by the publication of central bank indices, there has been an understandable hiatus as the impact of COVID-19 has been felt. The issues around market conventions for compounding, and the development of new loan and treasury management systems to support RFR loans, have not yet been resolved, nor has the calculation been fully settled of the credit spread above the RFRs to ensure that the transfer is value neutral. Once the immediate impact of COVID-19 has abated, attention will need to be turned to these once again.
During the extension period (i.e. the six-month period from the original deadline of end-Q3 2020 to end-Q1 2021), the RFRWG’s guidelines state that all new and re-financed LIBOR-linked loans should include a robust fallback mechanisms to enable transition to SONIA (or other alternatives) when LIBOR ceases. For example, through pre-agreed conversion terms or an agreed process for renegotiation.
Profile of litigation risks: impact of delay
Most loans currently being issued include more robust fallbacks of the kind envisaged by the RFRWG’s guidelines (i.e. including an agreed process for renegotiation when LIBOR ceases). However – importantly – the deadline relaxation will mean a further six months’ worth of facilities being written in LIBOR, which will increase the overall volume of LIBOR-linked loans in the market when the benchmark ceases.
The particular risks associated with fallbacks based on a requirement to renegotiate at the time of LIBOR cessation fall broadly within two categories:
- Commercial difficulties. An agreed process for renegotiation will only take participants so far: each transaction will still need to be amended on a deal-by-deal basis, though the LMA hopes that its exposure draft form of reference rate selection agreement will smooth this process in some cases. Accordingly, the way in which negotiations unfold on a loan by loan basis will reflect the relative bargaining strengths of the parties at that time.
- Practical difficulties. Continuing to increase the volume of loans which will subsequently require renegotiation upon the cessation of LIBOR (on top of legacy loans) will increase the practical challenges firms will face, and the time and cost burden, particularly for those with large books of bilateral loan facilities.
In summary, while pushing this interim milestone back by six months may provide some welcome breathing space in the cash market in the short term, it is not without cost. It will almost certainly increase the challenges firms face in the next stage of the process to achieve LIBOR transition in this market by the fixed deadline of end-2021. It is unlikely that this is the last adjustment to that timetable which will need to be made.
The Alternative Reference Rates Committee (ARRC) in the US has published a proposal for New York legislation to assist the transition of financial contracts away from US dollar (USD) LIBOR: Proposed Legislative Solution to Minimize Legal Uncertainty and Adverse Economic Impact Associated with LIBOR Transition (see the ARRC press release). Continue reading