- The final rule identifies replacement benchmark rates based on SOFR to replace overnight, one-month, three-month, six-month, and 12-month LIBOR in contracts subject to the LIBOR Act.
- The final rule codifies safe harbor protections for selection or use of SOFR as a replacement benchmark. It also clarifies who would be considered a “determining person” able to elect a replacement benchmark when USD LIBOR ceases to be published as representative on June 30, 2023.
- Under the final rule (codified in the Federal Register as Regulation ZZ), tough legacy contracts will be converted by operation of law to various forms of SOFR, along with a spread adjustment, upon a “LIBOR replacement date.”
- For derivative contracts the “Fallback Rate (SOFR)” which includes the applicable spread, will replace references to USD LIBOR.
The Bottom Line
The Federal Reserve Board on December 16, 2022, published final rules for Regulation ZZ implementing the Adjustable Interest Rate (LIBOR) Act. These rules allow for the final transition of tough legacy contracts from USD LIBOR to the Secured Overnight Financing Rate (SOFR). Together with the proposal from the UK’s Financial Conduct Authority (FCA) to allow for the publication of synthetic USD LIBOR, the new regulations should be the final piece of rulemaking for the transition from USD LIBOR to SOFR. The changes between the proposed Regulation ZZ and the final Regulation ZZ may be viewed here.
LIBOR, formerly known as the London Interbank Offered Rate, was the dominant benchmark rate used for decades to set interest rates for commercial loans, mortgages, derivatives, and many other financial products.
To end alleged manipulation of LIBOR, the UK Financial Conduct Authority (FCA) and U.S. banking authorities decided in 2017 to replace the USD LIBOR with the Secured Overnight Financing Rate. SOFR is an index based on the U.S. treasury security repurchase market. Due to its liquidity, SOFR is viewed as difficult to manipulate. USD LIBOR began to be phased out in December 2021, when most banks were encouraged to stop making new USD LIBOR loans. Currently published are USD overnight, one-month, three-month, six-month and 12-month USD LIBOR as applicable to existing cash products and derivative instruments. Those remaining tenors will cease to be published on June 30, 2023, except that per the FCA proposal, the one-, three-, and six-month tenors will continue to be published on a “non-representative,” synthetic basis until September 30, 2024.
How to Adjust to the Evolving Landscape
- Contracts that currently apply SOFR or another non-USD LIBOR rate–No need to make changes.
- Contracts that currently apply USD LIBOR but contain adequate features to convert to an alternative interest rate–Either effectuate an early opt-in conversion to SOFR, or apply the contract provisions on or about June 30, 2023.
- Contracts that currently apply USD LIBOR but contain inadequate or no conversion features and cannot be pre-negotiated (i.e. tough legacy contracts)–Apply LIBOR Act and Regulation ZZ to convert to SOFR on or about June 30, 2023.
- Contracts that currently apply USD LIBOR, contain inadequate or no conversion features, cannot be pre-negotiated and are outside of the scope of Regulation ZZ–Rely on proposed synthetic USD LIBOR until September 30, 2024.
Final Regulation ZZ
Congress passed the LIBOR Act on March 15, 2022, and the Federal Reserve published final rules implementing Regulation ZZ on December 16, 2022. Under Regulation ZZ, tough legacy contracts will be converted by operation of law to various forms of SOFR, along with a spread adjustment, upon a “LIBOR replacement date.”
A. What is a tough legacy contract that will be subject to Regulation ZZ?
1. LIBOR contract means any agreement which by its terms uses USD LIBOR as a benchmark.
2. A “tough” LIBOR contract is a LIBOR contract that either
a. contains no fallback provisions;
b. contains fallback provisions that (i) fail to specify a benchmark replacement; or (ii) fail to specify a determining person who is responsible for replacing LIBOR; or
c. contain fallback provisions that identify a determining person but the determining person fails to act by either the LIBOR replacement date or by the contractually agreed date.
3. Any LIBOR contract that contains fallback provisions that identify a benchmark replacement that is not based in any way on any LIBOR value (including the prime rate or the effective Federal Funds rate), is not a “tough” LIBOR contract that is subject to Regulation ZZ.
B. Which rate will apply to tough legacy contracts?
1. Derivatives which reference USD LIBOR will be replaced with the “Fallback Rate (SOFR)” which includes the applicable spread.
The “Fallback Rate (SOFR)” is defined in the 2021 International Swaps and Derivatives Association (ISDA) Interest Rate Definitions as “term adjusted SOFR plus the spread relating to USD LIBOR, in each case, for a period of the Designated Maturity provided by Bloomberg Index Services Limited (or a successor provider as approved and/or appointed by ISDA from time to time), as the provider of term adjusted SOFR and the spread, on the Fallback Rate (SOFR) Screen (or by other means) or provided to, and published by, authorized distributors.”
2. General LIBOR Contracts (not a derivative, consumer loan, FHFA contract or FFELP asset-backed security)
a. For contracts that reference overnight USD LIBOR–replace with SOFR, plus the spread adjustment.
Regulation ZZ defines SOFR as “the Secured Overnight Financing Rate published by the Federal Reserve Bank of New York or any successor administrator.”
b. For contracts that reference one-, three-, six- or 12-month USD LIBOR̶ - replace with the corresponding Chicago Mercantile Exchange (CME) Term SOFR product, plus the applicable spread.
3. Consumer Loans
a. During the initial year
i. For contracts that reference overnight USD LIBOR–replace with SOFR, plus a linear daily spread adjustment (calculated by Refinitiv).
ii. For contracts that reference one-, three-, six- or 12-month USD LIBOR ̶ replace with the corresponding CME Term SOFR product, plus a linear daily spread adjustment (calculated by Refinitiv).
b. After the initial year:
i. For contracts that reference overnight USD LIBOR–replace with SOFR, plus the standard spread adjustment.
ii. For contracts that reference one-, three-, six- or 12-month USD LIBOR ̶ replace with the corresponding CME Term SOFR product, plus the standard spread adjustment.
4. Federal Housing Finance Agency (FHFA)-regulated-entity contracts
a. Where the contract is for a Federal Home Loan Bank advance–replace with the Fallback Rate (SOFR), which is the same as derivatives.
b. Where the contract is not for a Federal Home Loan Bank advance
i. For contracts that reference overnight LIBOR - replace with SOFR, plus the spread adjustment.
ii. For contracts that reference one-, three-, six- or 12-month USD LIBOR - replace with 30-day Average SOFR, plus the spread adjustment.
5. Federal Family Educational Loan Program (FFELP) asset backed securitizations (ABS)
a. For contracts that reference one-month USD LIBOR–replace with 30-day Average SOFR, plus the spread adjustment.
b. For contracts that reference three-month USD LIBOR–replace with 90-day Average SOFR, plus the spread adjustment.
c. For contracts that reference six or twelve-month USD LIBOR–replace with 30-day Average SOFR, plus the spread adjustment.
C. Why are there spread adjustments and what are they?
Spread adjustments are designed to compensate for LIBOR being higher than SOFR in two regards. First, LIBOR is an unsecured rate while SOFR is a secured rate. Second, LIBOR includes term premia. The following static spread adjustments are designed to create parity between USD LIBOR and SOFR.
USD LIBOR Tenor
D. LIBOR Replacement Date–generally means the first London banking day after June 30, 2023.
In accordance, with the LIBOR Act, the final rule ensures that LIBOR contracts adopting a benchmark rate selected by the Board will not be interrupted or terminated following LIBOR's replacement. The final rule will be effective 30 days after publication in the Federal Register.
Ballard Spahr represents clients across public and private markets and throughout the capital stack in a wide range of complex debt and equity transactions. With more than 120 lawyers nationwide—and teams focused on specific industry sectors, project types, and deal structures—Ballard Spahr’s Finance Department has a long history of efficiently closing deals and delivering value to our clients as we work to achieve their business goals. Please contact us if you have questions about the LIBOR to SOFR transition.
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