A legislative solution may be necessary to ensure a smooth transition away from the London Interbank offered rate, or Libor, Secretary of the Treasury Steven Mnuchin said during his testimony to the House Financial Services Committee on December 5.
The success of the transition could be jeopardized by the absence in legacy contracts of clear fallback language specifying what happens when the benchmark rate goes away. Legislation, Secretary Mnuchin noted, could provide guidance on what rate should replace Libor in contracts with insufficient or no contractual provisions to deal with its loss — and prevent a disorderly exit from millions of Libor-based contracts.
Mnuchin did not identify a particular legislative solution. At SFA, we believe a strong option was put forward in November by the Alternative Reference Rates Committee (ARRC). The group includes SFA and was convened by the Federal Reserve to help find ways to deal with the Libor transition.
Because a significant portion of Libor-based financial products and agreements are governed by New York State law, ARRC proposed a New York legislative fix. Its first step addresses three areas of ambiguity: contracts that do not include any fallback language, contracts that fall back permanently to a fixed rate based on a static Libor rate as of day one, and contracts that require an agent to determine the rate and spread adjustment. In all scenarios safe harbor against potential litigation risk is received. In the first two scenarios the legislation mandates the use of SOFR and the parties receive safe harbor as the law requires the change to SOFR. In the third scenario where there is a choice to move to SOFR, the proposal suggests safe-harbor if the party chooses to move to SOFR.
The key components of the proposal, as summarized by ARRC, is presented below.
A legislative solution will provide much needed legal and economic clarity and make market-wide coordination significantly easier. That will reduce the risk during the transition away from Libor of widespread confusion and litigation. But legislative relief may be challenged under the Contracts Clause of the Constitution, which prohibits states from interfering with private contracts. For a deeper dive into the pros and cons of legislative relief, see SFA’s summary of Libor litigation risks.
It is a very positive sign that policymakers, including Mnuchin, have become strongly attuned to this issue. Many of our members have devoted considerable resources to managing this transition. As December 2021, when Libor will be retired, gets ever nearer, we will continue to work closely with regulators and elected officials to ensure cooperation between the industry and the policymaking community.