It could be the trailer for a thrilling movie, but whether it turns out to be a horror flick or a mystery depends on what happens before December 2021. That's when the financial community's reliance on the London Interbank Offered Rate (LIBOR) is expected to be phased out. Proposals are on the table, but the prospect of litigation over LIBOR fallback provisions should prompt parties to promote now the creation of clear protocols and legislation. While the coronavirus (COVID-19) has the immediate attention of the markets, and rightfully so, the key to success on the other side of the pandemic is to take care today of the things that will become urgent tomorrow.
LIBOR reflects submissions made by a panel of banks using available transaction data and their expert judgment. It is the benchmark rate on at least $200 trillion in financial contracts in the United States and $350 trillion worldwide, including those related to securitizations, floating notes, student loans and consumer mortgages. Because the rate depends on what banks report, it became subject to manipulation by banks who adjusted their LIBOR submissions to favor themselves and others, and did not reflect the rates they were using. In the wake of the rigging investigation came a search for a more reliable and objective standard and, since 2017, the credit markets have been imaging what a world without LIBOR may look like.
So Far, SOFR
In light of LIBOR's anticipated end, a committee of market participants, the Alternative Reference Rates Committee (ARRC), has recommended a U.S. replacement rate, the Secured Overnight Financing Rate (SOFR). SOFR is produced by the NY Fed and is "a broad measure of the cost of borrowing cash overnight" collateralized by U.S. Treasury securities used in the repurchase agreement (repo) market.
SOFR differs from LIBOR in that:
- SOFR is related to a broader spectrum of transactions than LIBOR and does not have a subjective component, so it is less easily manipulated.
- Since SOFR is pegged to U.S. Treasuries, it won't disappear.
- SOFR is an overnight rate, while LIBOR considered long and short term rates.
- SOFR is backwards-looking while LIBOR is prospective.
Elsewhere, other countries have been advocating for their own rates with their own transaction committees. For example, the UK's committee, the Sterling Working Group on Risk-Free Rates, has advocated for Sterling Overnight Index Average (SONIA), which is administered by the Bank of England. SONIA is based on "actual transactions and reflects the average of the interest rates that banks pay to borrow sterling overnight from other financial institutions." Europe has selected European Short Term Rate (ESTER).
ISDA Solution, But Uncertainty Elsewhere
While many groups are uncertain of the path forward, ISDA has a plan in place for those who are willing to sign on to it bilaterally. ISDA has created a protocol (through multiple market consultations) to amend derivatives with definitive trigger events and a fallback SOFR rate for contract parties who agree to the protocol in an effort to avoid market disruption and bridge the legacy agreement gap.
For existing contracts beyond ISDA, the unavailability of the LIBOR benchmark may be a triggering event that implicates "fallback" provisions. Such fallback language is often crafted to address temporary unavailability of LIBOR, but not necessarily a situation where LIBOR is entirely eliminated. It's the kind of contract ambiguity that could be susceptible to more than one reasonable interpretation, especially if it's applied to an unanticipated situation.
A Litigation Magnet
Uncertainty like this draws in litigious parties like a moth to a flame. There are already reports of investors making moves to acquire bonds that have this problem with the hopes of making hay from the inevitable litigation they plan to lead.
As an example of a potential dispute, consider what could happen if there is no functioning LIBOR benchmark, the trustee or agent responsible for the trusts or instruments involved exercises discretion to employ a substitute benchmark rate and this discretion causes a significant shift in value for the existing parties. In such a case, a party experiencing or anticipating a dramatic change in position may choose to commence litigation.
There is a chance legislative authorities will step in to remedy this. The ARRC has made a proposal to the New York legislature on a recommended statute to address legacy agreements governed by New York law.
The proposal is structured such that there would be a mutual "opt-out" for parties who do not wish to be bound by the statute at any time before or after the end of LIBOR. Otherwise, it would provide for an automatic transition for contracts that are silent to a fallback rate or where the legacy language falls back to a LIBOR-based rate. If there is discretion in the contract to choose a new rate, then this statute would also provide a safe harbor for the party choosing the replacement rate. Of course though, the legislation itself could end up being the subject of litigation. But with New York State focused on immediate COVID-19 issues, this is looking less and less likely to get attention this term.
As we discussed with Asset-Backed Alert recently, for trustees seeking to be proactive, there are two paths that they might pursue in New York. They could opt for an Article 77 special proceeding or a declaratory judgment, if a complaint has already been filed. In either proceeding, a trustee could seek judicial guidance on one or more of the following:
- whether the trustee's contract interpretation is correct;
- whether the trustee has the discretion to choose a new benchmark; or
- whether a given benchmark is a reasonable substitute based on the contract language.
Of course, the actions above may not be possible until the courts return to normal, but planning could begin now even with the market disruptions from COVID-19 that have created uncertainty around LIBOR. Markets will be keeping an eye on SOFR during this period to see how it differs from LIBOR during tumultuous times. Enthusiasm for it as a replacement rate could weaken. It has not gone unnoticed that the recent return of the Federal Reserve's Term Asset-Backed Securities Loan Facility (TALF) is pegged to LIBOR-swaps and not SOFR.
If litigation begins in this area, parties may look for guidance from other suits involving trustees' duties and discretion. Although recent RMBS lawsuits are not directly on point, investors may find support for arguments in some of the decisions and concepts that have been seen in RMBS litigation, including the rulings that certain conduct may be actionable if it significantly increases the risk of loss to investors, even if losses have not been incurred. Ultimately, there may be significant differences which would limit or avoid applying that concept in this context, but the example gives a sense of the nuggets investors may seek to mine from favorable precedent in this unprecedented situation.
Nicole Serratore, an attorney in the Insolvency, Creditors' Rights & Financial Products Practice Group of Davis & Gilbert, contributed to this post.
Originally published April 2, 2020.
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