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New York State has passed legislation that could help transition tough legacy contracts away from Libor towards using Sofr.
The bill “Libor Legislation” would provide a legal basis for contracts without fallback clauses to switch from Libor to Sofr once Libor ceases to be published or no longer thought to be representative.
“What it’s doing is giving that legal certainty to existing contracts,” says Peter Phelan, an independent senior advisor to Deloitte’s Centre for Regulatory Strategies. Previously Phelan was the deputy assistant secretary for capital markets at the Department of the Treasury.
“The way that these would normally be handled would be through litigation. If you had two parties to a contract and Libor stopped, an administrator might say, ‘we'll fall back to Sofr.’ The borrower may say, ‘I never agreed to Sofr when we originally signed the contract’, that would have to work its way through the courts.”
“The purpose of the legislation is to limit all of that litigation risk.”
An estimated $74trn of transactions using Libor would still be outstanding as of June 2023 (the end of US Libor publication). Though a majority can be addressed by industry wide protocols, the Alternate Reference Rate Committee (ARRC) estimates that $1.9trn is tied up in bonds and securitisations that do not have adequate fallbacks.
Concerns are being raised that the New York law would conflict with the Trust Indenture Act (TIA).
“The significance of the TIA is that there is a provision that says you can't amend or impair the rights of a holder without that holder’s consent,” says Paul Forrester, partner at Mayer Brown.
“Even under the New York legislation, if it were to impair a note holder, they may have federal rights under the TIA.”
As such there have been calls for the US federal government to enact similar legislation and to clarify concerns around TIA. The New York City Bar Association has also wrote there could be constitutional implications of the NY Bill.
Currently, the house subcommittee on investor protection, entrepreneurship and capital markets is holding hearings to determine if similar federal legislation is required to ensure a smooth transition from Libor. Industry bodies like the ARRC and SIFMA are in support of such legislation.
While the vast majority of Libor contracts in the US fall under New York law, there is still a significant number of Libor based contracts in other states, Forrester says.
“It’s not an insignificant amount. It's a big enough concern that the Federal Reserve was ultimately convinced to support federal legislation.”
In the UK, the Financial Conduct Authority (FCA) is consulting to determine if there is a need to develop a synthetic Libor for Sterling and that it is also considering the case for USD Libor. If the FCA were to extend a synthetic USD Libor, there is uncertainty in whether it would be applicable in US contracts.
“There is concern about whether synthetic Libor would work in US legacy contracts,” says Forrester. “Would a change to synthetic Libor be an impairment? Would it be a material adverse change to a holder?
Phelan goes further saying there would be little to no legal justification for US contracts to accept FCA authorised synthetic Libor.
“The FCA has explicit authority to regulate reference rates. However, there is no such authority in the United States. If the FCA were to utilise or create some form of synthetic Libor, it would not be recognised in US contracts the same way, and it can't be regulated the same way.”
The legislative approach eliminates the need for the publishing of synthetic Libor.
“This [legislation] really obviates the necessity for synthetic Libor,” says Phelan.
“There would be no requirement to have this concept of synthetic Libor on a go forward basis if you've got a safe harbour to transition existing contracts.”
With less than nine months until the US Federal Reserve’s December deadline for ending new Libor issuances, much of the market has yet to make the transition.
According to Isda, only 4.7 percent of USD OTC interest rate derivatives used Sofr in March.
A survey conducted by the ARRC of non-financial corporates found that more than 60 percent have not been offered non-Libor borrowing alternatives. Of that 60 percent, 70 percent have not discussed potential alternate rates with their banks.
Phelan says communication between banks and their corporate customers will be key.
“At this point, the next big steps are for institutions to start operationalising [their Libor transition] plans to the extent they already haven't, really starting to think through what the world will look like without Libor, issuing non-Libor based financial contracts and educating their consumers about it.”